Juta will insert

the book cover THE COMPETITIVE & OPERATING

here ENVIRONMENT OF THE SOUTH
AFRICAN BANKING INDUSTRY

Chapter 2
Author: Karlien Stemmet
Learning objectives
• Analyse the level of competition in the South African
banking industry by using the structure-conduct-
performance framework.
• Evaluate the structural variables that influence the
conduct & performance of a bank.
• Discuss the different types of barriers to entry that
exist in the banking industry.
• Interpret & evaluate the current competition policy
issues in the South African banking industry.
• Compare the most important performance indicators
pertaining to banks in South Africa.
1. Introduction
• SA Banking industry:
– highly concentrated
– Dominated by 4 major banks (ABSA; FnB; STB;
Nedbank)
– Oligopolistic market structure: mutual
interdependence

• Measure of competition:
– SCP-approach
– Contestability
– Direct approach
2. SCP Analysis
• Direct one-way causality between S→ C → P
2. SCP Analysis
• Two competing hypotheses:
– Market Power Hypothesis: high levels of concentration
encourage co-operative behaviour & reduce
competition
– Efficient Market Hypothesis: highly concentrated
markets result of superior efficiency.

• Feedback approach: no direct link between S-C-P

as conduct can alter the type of market structure
3.1 The number of firms
• A2 vs A1 banks
– Between September 1999 & March 2003 a total of
22 banks exited the South African banking system
3.1 The number of firms
• 2013:
– 17 registered banks – 6 controlled by foreign companies & 9 by
local companies
– 14 local branches of foreign banks
– 2 mutual banks &
– 43 foreign banks with local representative offices.
3.2 The level of concentration
3.2 The level of concentration
• Concentration indices: measure the number &
size distribution of firms in an industry.

• Various indices: market share, HHI, CR & Lerner

index.

• Other factors: size of incumbent firms, the

geographical constraints of customers, customer
interest & needs, switching costs, level of
contestability, regulatory requirements & product
differentiation.
3.2 The level of concentration
• Positive relationship between concentration &
financial margins/profits

• 3 main arguments:
1. Market share increases, concentration levels increase,
degree of market power increases, incentive to
increase prices, leads to higher margins & profits.
2. Banks are more efficient & consequently more
profitable, thus obtaining a larger market share.
3. High barriers to entry - higher prices, maintain high
margins & make excessive profit without fear of new
competition.
3.3 Market share & CR’s
• Define relevant market: drawing a boundary around
products or services that are truly substitutable.
– Identify competitors to calculate market share
– Different proxies to calculate market share
– Different approaches to classify substitutability of
products:
• Cluster approach
• Segmented market approach.

• Larger the market share = stronger degree of market

power.
3.4 Market power
Economic theory
• Market power: P > MC
• Competitive market:
• P = MC
• A firm only has control over
pricing if it has market power
• Market share not always true
indication of market power =
limitations
Competition Act
•Structural test
 At least 45% of market
 At least 35% but < 45%
 Less than 35% of market
but market power
•Behavioural test
 Power of a firm to control
prices, or
 exclude competition or
 behave to an appreciable
extent independently of its
competitors, customers or
suppliers.
12
3.5 Concentration Ratio (pg37-40)
• Concentration ratios indicate the extent to which a
relatively small number of firms control or dominate
the total industry.

• CR4:
– The sum of the market shares of the top 4 firms.

σ𝑘𝑖=1 Z𝑖
CR 𝑘 =
Z𝑡

• Higher CR → higher level of concentration → more the

market is dominated by a few banks.

13
3.5 Concentration Ratio
• Rule of thumb for the interpretation:
– CR4 = 0: perfect competition
– 0 < CR4 < 40: effective competition or
monopolistic competition
– 40 < CR4 < 60: loose oligopoly or monopolistic
competition
– CR4 > 60: tight oligopoly or the presence of a
dominant firm with fringe firms
– CR4 > 90: effective monopoly or a dominant firm
with competitive fringe
3.5 Concentration Ratio
3.6 Herfindahl-Hirschman Index (HHI)
(pp.40-44)
• HHI = sum of the squared market shares of all the firms
in industry
𝑛 2
Z𝑖
HHI = ෍
Z𝑡
𝑖=1

• HHI ranges between 10 000 & 10 000/n (minimum

value)

• Higher the value of HHI → higher the level of

concentration.
3.6 Herfindahl-Hirschman Index (HHI)

17
3.6 Herfindahl-Hirschman Index (HHI)

18
3.6 Herfindahl-Hirschman Index (HHI)
• Levels & classification according to HHI:
– HHI < 1500 → low concentration
– 1500 < HHI < 2500 → moderate concentration
– HHI > 2500 → high concentration

• Mergers:  in HHI: 2 x market share A x market share B

Guidelines: If the;
• pre-merger HHI < 1,500 → raises no competitive concerns
• pre-merger 1500 < HHI < 2,500 &  in HHI > 100 → raises
competitive concerns
• pre-merger HHI > 2,500 &  in HHI > 100 → raises competitive
concern & if  in HHI > 200 → likely to create/enhance market
power

19
4.1 Pricing Behaviour: Lerner index (pg44-
45)
• A measure of the difference between price &
marginal cost as a fraction of the product’s price.

𝑃 − 𝑀𝐶 1
𝐿= =−
𝑃 𝐸𝑑

• The index ranges from 0 to 1.

– When P = MC, the Lerner Index is zero; the firm has no market power.
– Lerner Index closer to 1 indicates relatively weak price competition;
the firm has market power.

20
4.2 Markup Factor
• Determine the factor by which MC is multiplied to
obtain the price of a good.

• Rearranging the Lerner Index

 1 
P  MC
1 L 

• The markup factor is 1/(1-L).

E𝑑
Profit maximising price = × MC
1 + E𝑑

21
4.3 H-statistic
• Measures how either price or output responds to cost
changes (input prices).

• Computed by the summation of the elasticity of

revenue relative to the factor price.

• H-statistic value ranges from negative ∞ to 1: (pg46)

– closer the value is to 1 the higher the level of competition.
– a value of zero (or less) indicates monopoly
– between zero & 1 indicate degrees of monopolistic
competition.
5. Limitation of Concentration Measures

• Industry definition & product classes.

• Market/Geographical Definition

• Other factors

23
6. The nature of the products
• Perfect competition: perfect substitutes / identical
– No control over price = perfect elastic demand

• Monopolistic competition: differentiated, yet

substitutes
– Little control over price = negative sloped elastic demand

• Monopoly: unique product with no close substitutes

– Total control = inelastic market demand & firms demand
6. The nature of the products
• Oligopoly: either homogenous or differentiated
– Mutual interdependence – non-price competition

• Two main types of advertising:

1. Informative
2. Convincing

• Two major types of product differentiation:

1. Horizontal product differentiation
2. Vertical product differentiation
7. Barriers to entry
• Barriers to entry refer to any variable that hinders or
prevents a new firm from entering a particular market

• Three main types of barriers to entry:

1. Exogenous barriers refer to structural characteristics of
the market over which an incumbent firm has no control
2. Endogenous barriers: strategically created by existing
firms to either eliminate or slow down the process for a
new entrant to enter the market
3. Government & regulatory barriers: barriers that are
erected by government or regulatory agencies.
7. Barriers to entry
• Main barriers identified in the banking industry:
– Regulatory barriers
– Advertising &/or product differentiation
– Switching costs
– Sunk costs
– Economies of scale
– Capital requirements
– Cost advantages

• Contestability & barriers to entry

8.Complex monopoly
• Complex monopolies exist in markets where:
I. there is little or no price competition
II. firms segment their customers in order to price
discriminate &
III. firms change prices excessively.

(be sure to go through pages 50-51)

8.Complex monopoly
• Section 10A8 states that:
‘A complex monopoly will be deemed to exist where: (i) two or more firms supply or are supplied with at least 75% of a
market’s goods or services, & (ii) such firms conduct their respective business affairs in ‘a parallel conscious or a
coordinated manner’, whether or not they do so voluntarily or with explicit agreement. Participation in a complex
monopoly conduct is prohibited where it prevents or substantially lessens competition within the relevant market & the
conduct resulted in:
– high barriers to entry to the relevant market
– exclusion of firms
– excessive pricing
– uniform or exploitative pricing, similar trading conditions or other indicators of parallel conscious conduct
– refusal to supply other firms within the market;
– other market characteristics that indicate co-ordinated conduct.’

• Complication when interpreting complex monopoly conduct

9. Pricing strategies in the banking
industry
• Kinked demand curve:
– if one firm increases its price → rivals will not match → firm
loses sales along a relatively elastic demand
– If one firm lower its price → rivals will match → a firm will
therefore gain few customers along a relatively inelastic demand
curve
– Kink at the current market price

• Different strategies:
– Pure bundling: consumer is forced to buy a bundle of identical
goods as a unit
– Mixed bundling: the consumer has a choice of either buying the
goods as a bundle or separately → complimentary goods.
– Tying: the consumer is forced to buy an unrelated product.
9. Pricing strategies in the banking
industry
• Number of different pricing & packaging options.
– Pay-as-you-transact: Single fee for every individual transaction
– Fixed monthly fee: for a limited number of bundled transactions.
– Rebate option: If a consumer keeps a certain amount in a bank
account for a certain period, pay-as-you-transact fees will be
credited to their account.

• Banks generally levy fees in three ways:

– The base fee per transaction is a fixed fee.
– Expressed as a percentage of the value of the transaction.
– The maximum payable fee.
10. Enquiry into the banking industry
• Investigations: Falkena II Report (2004), the FEASibilitY
Report (March 2006) & the Competition Commissions
Banking Enquiry (August 2006)

• All identified anti-competitive outcomes:

– Included high fees, poor quality service, high barriers to entry,
lack of innovation in the NPS, ineffective competition in retail
banking & financial exclusion especially of the poor.

• Market power of bank obtained & maintained by product

differentiation, asymmetric information, high switching
costs & fee complexity.
10. Enquiry into the banking industry
• 28 recommendations were made and
classified into five main groups:
1. Penalty Fees
2. ATM carriage fees
3. Access to the National Payment System (NPS)
4. Payment cards & interchange fees
5. Products & pricing
11.1 Nedcor/Stanbic Merger (1999)
Section 2.3.2 is very important
• November 1999: Nedcor (4th largest bank) attempted a
hostile takeover of Stanbic (2nd largest bank)

• Main reasons why SA Competition Commission opposed

the merger.
– New combined CR3 (Nedcor/Standard, ABSA & First National
Bank) would be 77.7%
– Retail banking segments, merger would enhance the market
power of the ‘new’ bank & lowered the ability of the remaining
banks to compete effectively
– Removal of an effective competitor (especially given the four
pillar policy)
11.2 Nedcor/BOE (2002)
• Ripple effect of demise of Saambou.
– Large withdrawals by wholesale depositors caused BOE to
approach the SARB for liquidity assistance → resulted in merger
between Nedcor & BOE (6th largest bank)

• Registrar of Banks & the Minister of Finance authorised the

merger → not assessed by Competition Commission owing
to time constraints & the urgent nature of the transaction

• Result:
– HHI increased from 1 470 to 1 750 (33.4% increase)
– CR4 increased from 69% to 81%.
– Number of major banks fell from 6 to 5
11.3 ABSA/Barclays (2005)
• Merger was approved by all relevant parties: Registrar of Banks,
Competition Commission, National Treasury, & Minister of Finance

• Main reasons for approval by Commission:

– no lessening or preventing of competition
– no removal of an effective competitor
– no change in the market structure or level of concentration.

• Minister, in accordance with section 37(2)(a)(iii) of the Banks Act,

approved the acquisition on the basis that Barclays would hold
more than 49% but less than 74% of the ABSA shares.
– Barclays owns 62.3% of ABSA in 2013.
12. Performance variables
• Efficiency is divided into three categories:
1. Allocative efficiency: resources are allocated to
production of goods that yield the highest value
to consumer.

2. Production efficiency: produce at lowest average

total cost (exploit all economies of scale)

3. Dynamic efficiency: incentive to innovate new

technology & research & development.
12.1 Return on average assets (ROAA)
• The ROAA compares the efficiency & operational
performance of banks as it considers the return
generated from the assets financed by the bank.
The formula for ROAA is:

ROAA = Net income after tax ÷ Average total assets × 100

• The higher the ratio, the higher the income

earned relative to the asset investment.
12.2 Return on average equity
(ROAE)
• The ROAE is a measure of the return on average
shareholder funds.. The formula for the ROAE is:

ROAE = Net income after tax ÷ Average total equity capital × 100

• The higher the ratio, the better the return shareholders

receive relative to their equity investment in the bank.

• The ratio should however be used with caution as it

may be at the expense of an over-leveraged balance
sheet
12.3 Net interest margin (NIM)

• The NIM expresses the value of the bank’s net

interest revenue as a share of its total assets as
follows:

NIM = Net interest revenue ÷ Total assets (or earning assets)

• Higher the NIM, the higher the margin the bank is

commanding.

• Higher margins & profitability are preferred as

long as the asset quality is being maintained.
12.4 Cost-to-income ratio (CTI ratio)
• Measures how efficient a bank is by
expressing its overheads (or costs) of running
the bank as a percentage of the income it
generates (before provisions):

CTI =
Total operating income ÷ Total operating expenses × 100

• International benchmark regarded to be 60%