Banking Competition

Danes Quirira Octavio

Competition: the definitions
• The act or process of trying to get or win something (such as a prize
or a higher level of success) that someone else is also trying to get or
win : the act or process of competing
• Actions that are done by people, companies, etc., that are competing
against each other.
The effect of competition
General effects:

• Lower cost
• Enhance efficiency
Competition in Banking Markets
• Why is the level of competition important?
Competition drives
• Bank Strategy
• Competition and Regulatory Strategies
• should we allow more mergers?
• should we add greater customer protection rules?
• Empirical findings for the relationship between
bank competition and financial stability are not
clear
Competition and Financial Stability:
Competition-fragility hypothesis.
• Competitive and/or less concentrated banking systems are more
fragile.
• The ‘‘charter/franchise value’’ of banking, as modeled by Marcus (1984), Chan,
Greenbaum, and Thakor (1986), and Keeley (1990), suggests that competition
drives banks to undertake risk-taking strategies due to the contraction of the
franchise value.
• A higher charter value arising from increased market power may deter
excessive risk-taking by the bank’s management.
• Perfect competition might prevent banks to provide liquidity to a peer (inter-
bank market) (Allen & Gale 2000)
• Fewer banks are easier to supervise (Allen & Gale 2000)
Competition – Stability Hypothesis
• Competition leads to greater stability
The argument of market power enhances profitability and ultimately bank
stability ignores the behavior of the borrower.

• Concentrated banking firm leads to greater market power, allowing banks to

increase interest rate (Boyd & De Nocolo 2005)
>>> Borrower will choose higher risk.
Competition – Stability Hypothesis

• Fewer banks are easier to supervise?

A less competitive banking market may lead to more risk-taking. Why? More big
banks in the market.
Too big too fail banks obtain implicit (or explicit) subsidies via government
safety nets (Mishkin, 1999).
Measuring Competition
• Structural approach
• Non Structural approach
Structural Measures
§ Possible Measures include
§ Number of Banks
§ Number of Branches
§ Branch Density
§ Market Concentration
§ Ownership Structure

§ In general
§ more banks (competitors) is taken to imply more
competition

9
Market Concentration
• The structure of an industry can be characterised by
• the number of firms in the industry at a given moment in
time
• the size distribution of firms

• Commonly used concentration measures include:

• Concentration Ratios
• the Herfindahl-Hirschman Index
Concentration Ratios
• The concentration ratio (CR) measures the market share of the
top N firms in a specific market, where N is normally 3, 5 or 10
• The higher the ratio (i.e. closer to 1 or to 10,000 depending on
specification), the more concentrated the market
N
CRN  x
i 1
i
where
xi is the market share of firm i
N is the number of firms in the industry
For example
CR-3 Ratio => largest 3 firms in the market
CR-5 Ratio => largest 5 firms in the market
Herfindahl-Hirshman (HH) Index

• where si is the market share of firm i and N is the total

number of firms in the industry
• shares of loan or deposit market often used
• gives a scaled value of between 0 and 1 or between 0 and
10,000 (is a 10% market share 0.10 or 10?)

• In the case of monopoly HH = 1 (or 10,000)

• In the case of equal sized firms HH = 1/N (or 10,000 /
N)
• HH increases as the size distribution of firms becomes
more unequal
Non-Structural Measures (cnt’d)
Panzar-Rose (H-Statistic)

P = Interest revenue/TA
Wn = Input price (interest expense, personnel expense, other operating and administrative expenses)
Yn = (Equity/TA, Net loan/TA, LogTA)
D = Vector of dummy year.
 Widyastuti, R.S., and B. Armanto. (2013).
Banking Industry Competition in Indonesia.
Bulletin of Monetary, Economics and Banking,
15(4), 401-434.
 Non-Structural Measures
• Lerner Index (Market Power)

Wn = Input price (interest expense, personnel expense, other

operating and administrative expenses)