Competition, Concentration and Efficiency of Commercial Banks in South Korea, Mainland China and Taiwan 9789814298278, 9789814298261

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Enrich Series on China's Economic Issues This series emphasizes the employment of modern economics methods to explore and research hot-spot issues and difficulties in the reform, openingup and economic development facing China today. It covers a wide variety of economic issues ranging from monetary policy, fiscal policy, regional economy to industrial and banking development.

Vol. 1

China's Opening-up: The Impact on Monetary Policy Choice

Vol. 2

Growth of the Service Sector in the Yangtze River Delta

Vol. 3 Foreign Trade Growth and Economic Development in China: Retrospective and Future Prospects Vol. 4

A Study of the Macroeconomic Effects of China's Fiscal Deficits

Vol. 5 Competition, Concentration and Efficiency of Commercial Banks in South Korea, Mainland China and Taiwan

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660

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Rm 1108A, Culture Plaza, No. 59 Zhongguancun St., Haidian District, Beijing, China English edition © 2012 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2008 China Renmin University Press Translated by Li Yanmin and Xing Xiao Qiao All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage

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Contents Preface to the Series

vii

Abbreviations ix

Chapter 1

Introduction 1

Chapter 2

Literature Review on Banks Competition

Chapter 3

Measurement of Competition and

17

Concentration of Banks

51

Chapter 4

Measurement of Banking Efficiency

93

Chapter 5

Empirical Researches on Competition,

Chapter 6

Concentration and Efficiency of Banks

127

Conclusion and Policy Suggestions

157

Appendix 175 Notes 183 References

193

Index 203

Preface to the Series The development and change of economic theory is closely associated with economic practice. With the transition of China to a socialist market economic system, practice requires the development and prosperity of economics; at the same time, practice is creating the conditions for the development of economics. Market-oriented reform in China is unprecedented and no ready-made economic theory can be used for guidance. This is a major challenge for Chinese scholars. “By other’s faults, wise men correct their own.” With the translation and introduction of a large quantity of Western economic theories to China and the growth of many skills in modern economics attainment, brand-new tools and perspectives are available for the understanding and solving of the economic problems of China. Theory and practice are interactive. While using modern economic theory as reference, China, as an unparalleled “test field,” will certainly inject new vitality into the development of economic theory and become an important driving force for its development. Only in this way may economics based on researches on Chinese economic problems be established. It is against this backdrop that Chinese economic issues are endowed with special significance. The fundamental purpose of planning for and publishing the Series on Economic Issues in China is to encourage economists’ spirit of innovation and exploration, further promoting the development and prosperity of economics research in China, and to establish a platform that is suitable for the growth of new ideas among economics works in China, providing a theoretical economic circle on China and explorers in real sectors a space for presentation of highlevel research findings, thus enabling this series to be indispensable reading for readers at home and abroad to learn about the development of economics and the economy in China. The distinctness and urgency of economic issues in China will provide Chinese scholars with a broad space for development. Using economic issues in China as the breakthrough point, this series emphasizes the employment of modern economics methods to explore and research hot-spot issues and difficulties in the reform and opening-up and economic development of China. For the purpose of development of the Chinese economy and economics, on an academic basis, this series has employed a “double-blind review system” integrated with solicited manuscripts from experts so as to cultivate a number

Preface

of Chinese academic pioneers with the spirit of rationality and exploration in the field of economics. China is an ideal country for economic research, where the diligent may make plentiful and substantial achievements.

viii

Abbreviations BL Model Bresnahan and Lau Model CPC Communist Party of China DEA Data Envelopment Analysis DFA Distribution Free Approach DMU Decision Making Unit ES/ESH Efficiency Structure Hypothesis GDP Gross Domestic Product HHI Herfindahl Herschma Index KRW Korean Won NPL Non-performing Loans NTD New Taiwan Dollar OECD Organization of Economic Cooperation and Development PR Model Panzar and Rosse Model RMB Renminbi ROK Republic of Korea ROA Return on Assets ROE Return of Equity SCP Structure — Conduct — Performance SFA Stochastic Frontier Approach TFA Thick Frontier Approach

1

Chapter

Introduction

COMMERCIAL BANKS

Research Motivation Changes in the international environment In the 1970s, the financial deepening theory put forward by R. J. McKinnon and E. S. Shaw, American economists, laid a theoretical foundation for financial liberalization and thus opened the prelude of worldwide financial reform with financial liberalization at the core. The wave of financial liberalization swept across the world before the financial tsunami in 2008 and the world banking system had witnessed four major significant changes. Deregulation Countries across the world relaxed restrictions on many aspects, including interest rate, business scope, market access, capital flow and stock ownership. From the perspective of the content, the deregulation includes mainly the lifting of interest rate controls and credit rationing in domestic business and the abolition of capital flow regulation and foreign exchange limitations in international business. Financial liberalization is in essence a change of government behavior in finance. The U.S. promulgated the Riegle-Neal Inter-state Banking and Branching Efficiency Act and the Financial Services Modernization Act in 1994 and 1999 respectively, allowing banks to set up inter-state branches, establish subsidiaries of industrial holding companies and conduct mixed operations, which put an end to the 66-year-long separate operational structure of banks, securities and insurance and resulted in fierce competition. Internationally, prudent control has been strengthened and the deposit insurance scale has been expanded accordingly. Unprecedented wave of mergers and acquisitions of the banking industry In the 1990s, more than 4,000 banks concluded their reorganization and merger with a trading volume of USD1.2 trillion in leading industrialized countries. Between 1997 and 2003, the number of banks in 15 member states of the European Union (EU) alone dropped from 9,100 to 7,500.1 American Citibank, a well-established bank in the global financial community, merged with Travelers Group specializing in insurance business and investment in banking operations in April 1998. The merged group is known as Citi Group with a merger capitalization of as much as USD82 billion. 2 The new group has 100 million companies and retail clients in 100-plus countries worldwide and can provide all-round financial services, including commercial banking, insurance, fund

2

Introduction

management and security exchange business. In February 1999, Société Genéralé and BNP Paribas, the second and the fifth largest banks in France, announced their merger to become the largest French bank, the third largest bank in Europe and the fourth largest bank in the world. These merger and acquisition activities have greatly changed the international financial structure and become a hotspot of the international financial community. With the acquisitions and mergers between large and small banks and among large banks, the number of banks and their branches has shrunk dramatically. Historically, the American financial industry has a different point of view from other countries in terms of competition. The traditional belief of the Americans is to decentralize powers, advocate competition and put a high value on the social benefits generated from the unit banking system, which has put a brake on the expansion of American banks geographically and on their other activities to make diversified investment. Throughout the 19th century, American banks did not develop nationwide and extensive branch networks like other industrialized counterparts did, but rather they were highly decentralized. Before the Civil War, American states regulated their banking system by themselves, many states settled for a banking system allowing free access, and a nationwide banking system did not exist. The Civil War broke out in 1861, and the federal government changed its role in the financial system in order to raise funds. In particular, the decree promulgated in 1864 stipulated that a bank could only operate in one place and not set up branches, which guaranteed the existence of a large number of banks. Government employed strict regulations to maintain competition and the anti-trust policy of the judicial department also produced strong results in maintaining competition in the banking industry. All these approaches conform to American values as it is generally believed that this can ensure market competitive value and encourage the effective operation of banks. In other countries, the banking industry had become relatively concentrated many years ago under both the market-oriented and bank-oriented system. 3 As a case in point, UK banks established networks nationwide in the late 19th century, but only five leading banks were left by the early 20th century. During that period, the government actively encouraged and guided this change. Other industrialized countries also went through the process of merger and acquisition and the establishment of nationwide banking networks. Over the past many years, concentricity has been the main feature of the banking market structure in developed countries, including Japan, Germany and France. The grave economic and financial crisis which took place in the U.S. between 1929 and 1933 changed people’s perspective on competition and directly gave

3

COMMERCIAL BANKS

birth to the Glass-Steagall Act in 1933. As with other countries, the U.S. also gives top priority to financial stability. This Act introduced key provisions for financial stability such as the deposit insurance system and separate operation. During this period, the viewpoint that “monopoly profits may help banks better digest shocks” emerged in theory. If one bank has serious problems, the government would advise and encourage other banks to take it over. Merger and acquisition have given birth to some huge banks in the financial industry and the operational efficiency of the financial sector has been improved through lower costs and fierce competition; increasing credit supply and improving service quality through stimulating economic growth gave a strong boost to the entire economy. At the same time, the market strength of larger banks enhanced the security and stability of the financial industry. An array of reforms ultimately eliminated banking panics. But the same target had been met in the UK as early as 70 years before. Extensive application of new technologies The revolution of tertiary industry featuring information communication technology launched the era of the new economy and the network economy, and had a huge impact on the financial industry. The emergence of selfservice equipment such as online banking has greatly changed the competition landscape of the banking sector. From tangible competition to intangible competition, the importance of major indicators for the banking system, including the asset and capital amount and the number of branches decreased relatively, and the financial innovation degree of bank electronics, the capacity to process information and to provide clients with quality services have become the focus of banks in competition. Banks in the e-commerce era have improved their competitive value and established their competitive edge by relying on advanced technologies. That means the competition mode in the network economy is “fast fish eating slow fish” rather than “big fish eating small fish”. The biggest challenge for modern commercial banks is whether they can catch up with the development of modern technologies. Modern technologies enable banks of any scale to purchase the most advanced computer system with the least investment and access their clients at home or in their offices with the most sophisticated banking software, as information technology is an instrument that can be employed by banks of any size. Hugh L. McColl, Chairman of the Bank of America, noted in his speech at the School of Management of the Bank of America that American commercial banks are facing unprecedented opportunities in the e-commerce era, and the future winners

4

Introduction

will be those banks which can integrate the banking business process with information technologies and roll out new financial products in a timely way in line with the requirements of their clients.

Significant increase in the book capital funds of banks With global economic integration, competition in the financial field and competition between multinational banks in particular have become

increasingly fierce. The ever-changing financial innovations have made banking business diversified and complicated, financial derivative products and the

scale of trading have quickly picked up, financial crises with banks playing

the leading role keep occurring, and the operational environment of banks has undergone huge and profound changes. It is difficult for the Basel Capital

Accord developed in 1988 to address new problems and changes, which led the Basel Committee to amend the original agreement in a major way and resulted in the development of the New Basel Accord in 2004. The issues of risk management of banks have attracted more and more attention of national governments. In most countries, supervision of modern banks depends on three pillars: prudent supervision regulated according to capital sufficiency, deposit insurance for rescue efforts or crisis management, and the framework of setting inter-bank rules of competition. The first two pillars have caught the attention of the academic community and the public sector and have been widely discussed and studied. In recent years, the relationship between inter-bank competition and concentration on the one hand and efficiency and stability on the other has become a hot topic in theoretical circles. Deregulation has stimulated consolidation and resulted in a worldwide wave of mergers and acquisitions. Cross border capital flow, the enhancement of market contestability and the privatization process have stimulated market concentration. On the one hand, the mainstream observation is that increased concentration may intensify market strength, which will have negative impact on competition and efficiency; on the other hand, another argument is that concentration can improve efficiency if the reorganization and merger of the banking industry can promote the economy of scale; from the policy perspective, it is difficult to judge the implications of banking structural changes for the competition environment on one part and the efficiency and stability of the banking sector on another. Since 2000, the World Bank and the European Central Bank (ECB) have convened workshops on this subject respectively and have shared insights on it.4

5

COMMERCIAL BANKS

Special requirements for the banking industry’s efficiency and stability The developed modern economy cannot be talked about without highly efficient finance. Banks offer and exchange financial assets, function as intermediaries for savings and in the meantime bear and spread risks via delivering credit to consumers and manufacturers. As such, the banking sector has provided enterprises and consumers with necessary financial services, which has boosted economic development. Conditions for the efficiency of a financial system include competitive prices, the lowest trading costs, and market integration. One of the outstanding features of the financial system is instability and the system is more vulnerable than other industries. In the development history of finance, large defects have been demonstrated in the market by the South Sea Bubble of the UK,5 the Great Depression in 1929, “Black Monday” in 1987 and the burst of economic bubbles in Japan and the Republic of Korea in 1997. Internally, the vulnerability and frequent crises for the banking sector are mainly because: (1) There are soft constraints on bank debts and hard constraints on assets. (2) As a result of the high leverage relationship between assets and debts in finance, banks objectively have the motivation to engage in high-risk businesses. (3) One possible effect of the competition in the banking industry and the shrinking profits due to the competition is the increasing motivation of banks to run risks. If they succeed, shareholders will benefit; but if they fail, lenders will bear the costs. Major debtors are savers, but they have few claim rights; they are decentralized and have little access to the business status and potential risks of banks. Bankruptcy of banks may give rise to true economic and social costs and they will pay heavy prices. Banks connect a host of networks (such as the inter-bank market and payment system), and the fluctuation of one bank will trigger a chain effect in other banks (the communicable disease effect), which has driven up the potential risk costs dramatically. The Great Depression which happened between 1929 and 1933 destroyed a large number of banks. What has happened proves that financial turmoil is sufficient to break down the economy. Different banking systems have different structures. The structure and stability of the banking industry are closely intertwined but they are different in sensitivity to issues. A decentralized banking system has many small banks and its sensitivity to panic and turbulence is much higher than that of a concentrated banking system from the historical perspective. One of the reasons for the instability of the decentralized banking system is the weak strength of a small bank. As they are small in size and weak in strength, economy of scale is not possible and their business is relatively simple and easily affected by volatility

6

Introduction

and turmoil; in addition, small banks have poor credit, little financing access and poor asset liquidity. It is hard for them to get through difficulties once these have occurred. Another reason is interdependence. Small-sized banks always try to seek help via inter-connection between banks. Yet crisis will be spread from one bank to another and lead to chain panics when this interconnection is challenged in some way. In the first half of the 19th century, the decentralized banking system in the UK suffered quite a number of financial crises and panics. In late 19th century, it witnessed merger and acquisition on a large scale and the market structure became more concentrated. Meanwhile, the banking sector became more and more developed and transparent thanks to market adjustment and government regulations. The possibility of crisis and turmoil became less likely and basically disappeared in the end. Many scholars believe that three factors, namely economic scale, technological advancement and government regulations, can underlie the development of an industry. When we look at the history of banking development the market has many defects and imperfection, such as prominent information asymmetry, moral risks and so on, which cannot be addressed without active and effective government intervention. The industrial organization structure of the banking system is what underlies the efficiency and stability of the sector, and the government can develop game rules to exert influence on the financial system and market. As special businesses, banks have specific requirements on the relationship between stability and efficiency. Conflicts often occur between policies on restricting competition to acquire stability and theories on encouraging competition to improve efficiency. On this matter the government must seriously study market conditions, weigh up the pros and cons between stability and efficiency, and settle for banking regulations and policy suggestions which reflect national realities.

Unprecedented challenges encountered by the traditional industrial organization theory The opinion that competition brings about potential profits comes from the application of the theory of standard industrial organization in banks (Freixas and Rochet, 1997). In fully competitive markets, banks are the takers of prices and they provided the maximum credit at the lowest price, which has led to the lowest costs and prices. In contrast, in places where there is market strength, banks are capable of collecting fees at higher than marginal costs. As such, banks will cut back on credit amount while demanding higher prices.

7

COMMERCIAL BANKS

As is known to all, traditional industrial organization theory holds that a competitive banking industry is featured by a large number of small banks. As with other industries, potential profits are generated from the competition among many small enterprises. Competition maximizes welfare through offering the most credit with the lowest price, and competition guarantees minimum costs and the efficiency of resource allocation of banking services. In other words, competition can improve the efficiency of the banking industry and make the industry share the benefits of the financial system with other sections on the one hand. On the other hand, banks will seek a higher interest rate for loans if they obtain market powers. Higher costs of banking services will drive up not only trading costs but also costs for industrial capital financing. Industrial concentration is the most commonly used indicator to measure industrial competitive value and monopoly. Traditional industrial organization theory takes industrial concentration as the most critical indicator to reflect market competitive value. Its basic logic is that a higher concentration indicates that less sales volume or other economic activities are controlled by part of the enterprises. In this sense, this small part of businesses enjoy considerable market control power, and price control power in particular, which has resulted in a low level of competitive value. The basic logic of traditional industrial organization theory is to connect concentration with the number of banks and draws the following three conclusions: (1) competition and the number of enterprises have positive correlations; (2) competition and concentration are contradictory; (3) full competition may improve efficiency. On the one hand, the financial services sector has obvious differences with other industries in many aspects. As traditional industrial organization theory more often than not comes from the manufacturing industry, its model is better applied to describe non-service sectors; past theories usually skirted the issue of whether the financial sector and non-financial sectors met the same law of competition. In practice, we find that most countries pursue a fully competitive free market economic principle, but the banking industry basically adopts a relatively concentrated market model (such as in the UK, Japan, France and Germany). The U.S. has started to reflect the drawbacks of the decentralized market structure of its banking sector and has made some adjustments in law. On the other hand, the financial services sector coupled with wave of mergers and competition is witnessing dramatic changes. The increase of alternative and integrated financial products of all kinds has been challenging the traditional industrial organization theory, the measurement method for market structure

8

Introduction

is far from meeting the complex market demand, and the relationship theory between competition, concentration and banking efficiency has been constantly overturned and become more and more complex.

Requirements of the development and opening up of China’s banking sector If we regard the Third Plenary Session of the 11th Central Committee of the CPC in December 1978 as the starting point of China’s reform and opening up, then the reform of state-owned commercial banks up to now can be generalized into three steps of strategy, namely commercialization, demutualization and going public. By 2001 the first step, commercialization, had yet to be accomplished in a real sense after more than two decades. The basic landscape of state-owned banks at that time can be described as “high, low, poor”: a high proportion of non-performing loans (NPL), a low level of capital adequacy ratio, and poor earning capacity. On top of that, the corporate governance structure lagged behind. Taking the four major state-owned commercial banks as examples, in the lead up to state capital injection the loss of assets was more severe, RMB900 billion were lost in NPL and RMB400 billion in non-credit losses, and thus there would be no capital base when these losses were allowed for. In 2001 the per capita profits of the four leading state-owned commercial banks was recorded as RMB10,000, 4% of that of foreign-invested banks in China. 6 As banking reform lagged far behind the rapid economic growth and as the reform deepened, the underlying problems accumulated and constrained each other, many institutional and structural problems in the banking sector could not be tackled after having accumulated for a long time put a brake on Chinese economic development. Demutualization and going public, the latter two steps of strategy, are the results of the five years following China’s entry into the World Trade Organization (WTO). Thanks to the torrent of changes such as changes of equity, the key factor, in recent years, the marketization level of the entire banking industry in China has been improved and the problems of “high, low and poor” have been changed greatly. For China’s banking sector, the five year protection period regulated by the WTO came to an end in 2006 and China’s banking sector had to open up to foreign investment. After addressing the equity-related issues, the market structural problems i.e. competition, concentration and efficiency represented unavoidable problems. In this connection, evaluating the relationship and trends among competition, concentration, efficiency and stability for one part and sharing insights on the relationship between concentration and market

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COMMERCIAL BANKS

structure for another are highly relevant for the financial system to maximize social welfare and promote economic growth targets. In the financial sector, global mergers and the trend towards concentration have caught the attention of policy makers with the results. This in the meantime also makes people worry that a series of problems have yet to reach

a conclusion in economics. We notice that studies on this aspect are rare. Policy makers aim to bring convenience to the banking system and maintain economic

efficiency and stability. However it is hard to meet this target, and this involves three basic problems. First, what is the optimum competition structure, full

competition or monopoly or something in between? How to demonstrate the characteristics of the banking industry? Second, what should a banking

structure of this kind be? What about the relations between competition and

the number of banks? What is the relationship between competition and

concentration? Third, will full competition enhance the efficiency of the banking sector? What is the relationship between competition and efficiency? These contents are the focus of this book.

Research Method, Framework and Sample Selection The major research object of this book is the commercial bank. We select the

panel data of commercial banks in three markets namely the Republic of Korea,

Taiwan and Mainland China between 1996 and 2005 as samples. The book probes the industrial organization structure through the analysis of microsubjects with the purpose of studying the relationship between competition,

concentration and efficiency of the banking industry in emerging industrialized countries or regions and China on the one hand, and their development trend on the other.

The measurement of competition and concentration When it comes to the measurement of competition and concentration there are two methods, namely structural and non-structural ones. The structural

method comes from industrial organization theory which measures the market competition landscape from the market structural perspective (such

as concentration ratio). In the recent dozen years, most foreign mainstream

literature has settled for the non-structural method — the Panzar and Rosse (PR)

model (1987) — to measure the market competition landscape of the banking industry.

10

Introduction

The basis of the PR model is the Cobb-Douglas production function that

employs the standard comparative static analysis method. Since the 1990s, more

and more scholars have applied this model to empirical studies of the banking sector. The model indicates changes of input prices in the income of a bank

(balanced), that is the bank will decide input costs to define different pricing based on different market structures. Through analysis of the elasticity of

changes in the total income and input costs of banks, we can deduce the market condition of banks. The strong point of this method is that we can make an overall quantitative assessment of the market condition of the banking sector.

This book employs the structural method to measure the concentration ratio

CR 5 and the PR model as the non-structural method to measure the market competition landscape of the banking sector.

The measurement of efficiency What needs to be particularly noted is that the researched efficiency in this book is the efficiency of banks rather than the efficiency of the overall macroeconomy. The basic measurement method of the efficiency of commercial banks domestically employs data envelopment analysis (DEA). This method is a nonparametric linear model and its defect is that it cannot test the effectiveness of statistics, which does not agree with the research purpose of the book. On this subject I try to employ the parametric approach — the stochastic frontier approach (SFA) and non-linear model to meticulously describe the relationship between explanatory variables and explained variables. From the perspective of the test results, we can learn that the non-linear relationship is more stable. As the purpose is not to describe the efficiency of one bank then rather it employs the econometrics approach to study the changing trends in the efficiency of the three markets over the recent ten years. Therefore the parametric approach is preferable. In line with the characteristics of commercial banks in emerging economies, this book draws on the model of developed markets in foreign literature and tries to improve the model and use the maximum likelihood estimator to make the description of the model more objective.

The relationship between competition, concentration and efficiency According to the conclusions of the above two parts, the correlation analysis method and the regression method of econometrics are adopted to analyze the relationship between concentration, competition and the numbers of banks on the one hand and the relationship between competition and efficiency on

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the other. We can learn that the conclusions for the three markets are different. The relationship between competition and efficiency are different in different development stages of one country or region and in different environments. Generally, competition can promote the efficiency of banks; when competition

turns white-hot (excessive competition), competition and efficiency have a negative correlation; and competition can coexist with concentration.

Policy suggestions for the development of China’s banking sector At the end of 2006, China’s banking sector fully opens up. Therefore, how to design and plan the market structure of commercial banks to conform to China’s

reality and to balance competition and efficiency? This book will put forward some policy suggestions based on the results of the above research.

Much foreign literature has made analyses of the market structure of

commercial banks of developed industrialized countries, but there is little

research on that of Asian countries. We can see from Table 1.1 that if we divide

national development into several levels, China is far from the developed countries (such as the U.S., the UK and Japan) as China’s per capita GDP is

only about 3.5% of that in these countries; when compared with emerging

industrialized countries and regions (such as South Korea and Taiwan), China’s per capita GDP equals 9.5% of their GDP. Due to differences in economic

development level, China has a long way to go in terms of its political and economic system, marketization degree and way of thinking among others, compared with the developed economies. It is irrelevant for China to draw

on comparative studies of these markets. South Korea and Taiwan are Asian

and have little difference with China as they are similar in geographical

environment, the ideas of the government or the authority, and the thinking

of regulators and behavior of operators. It is more relevant and valuable for China to study the experiences and lessons of South Korea and Taiwan in the development and changes of the banking market in their financial reforms than those of Japan, the U.S. and other developed countries. Taiwan is selected

simply because it is also a part of China and its cultural background and way of thinking are quite similar with that of Mainland China; while South Korea is also similar to China in the banking sector as both are government-guided. South Korea and Taiwan have gone through the stages of financial liberalization

and internationalization and have typically realized industrialization are in the

mature growing stage. Today’s South Korea and Taiwan are much likely to be the tomorrow of China.

12

Introduction

Table 1.1.

International (Region-wide) comparison of per capita GDP in 20057

Countries or regions

U.S.

UK

Japan

South Korea

Taiwan

China

Per capita GDP (USD)

42,076

36,977

36,486

14,649

13,926

1,352

Source: International Monetary Fund (IMF), World Economic Outlook Database.

The total of the bank assets collected in each market surpassed 85% of the

total volume of the banking industry. The sample and conclusions can represent the characteristics and the trend of the market.

Outline of Contents, Structure of Essay and Innovations Chapter 2 reviews the documents on the best competition market structure of banks, discusses the optimum competition structure of banks and the characteristics of the competing banking sector respectively, and introduces the mainstream opinions and the latest achievements of the foreign academic community in this field. Chapter 3 measures competition and concentration. First and foremost, the chapter introduces the structural and non-structural methods for measuring competition. This book employs concentration ratio and the PR model to measure the market of the banking industry. The PR model reflects changes of input price in the income of a bank (balanced), that is to define different pricing in accordance with the input costs determined by different market structures. The H value is used to measure competition and its range is divided into three demarcation points to differentiate full competition, monopolistic competition and monopoly (full conspiracy). The structural measurement approach has difficulties addressing competition space and geographical span of the banking sector. The PR model employs banking level documents to assume that the market is balanced and discusses balanced output and balanced amount of banks under the premise that individual banks and the entire banking sector have realized maximum profits. This book uses the same model, the same explaining and explained variables, includes all kinds of expenses, material resources and capital costs of banks in South Korea, Taiwan and Mainland

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COMMERCIAL BANKS

China as input, takes interest income and non-interest income as output, and then uses the panel data of banks to estimate the parameter value and calculate the H value of the annual market competitive value in each market between 1996 and 2005. According to the study: (1) The basic business type of the market structure of commercial banks is monopolistic competition that is determined by the specific characteristics of the banking industry. (2) The competition behavior of banks and the number of banks in the market or their concentration ratio are not necessarily connected and competition and concentration of banks can coexist. Chapter 4 measures efficiency. This section introduces the non-parametric DEA approach frequently used by the domestic academic community, analyzes the merits of this method, and finally selects a parametric approach — the SFA. The SFA model was developed from the researches of Aigner, Lovell and Schmidt (1997). One of the important features of the SFA model is to consider inefficiency factors in the stochastic error term and to count the noise and inefficiency factor to form the stochastic error term, but they are mutually independent and subject to different distributions. Therefore, under the circumstances that residuals are already known, the counting of noise and inefficiency parameters can be separated so as to get the inefficiency value. This book properly adjusts this form of production function, takes operating expenses, capital and material costs as input and the income as output to consider the non-linear relationship between explained variables, and more accurately describe the relationship between explaining variables and explained variables. The maximum likelihood method is employed to evaluate the model, which can make us understand that the input and output of banks have a stable non-linear relationship. Chapter 5 talks about the relationship of the two levels based on Chapters 3 and 4: (1) the relationship between banks’ competition, concentration and the number of banks; (2) the relationship between banks’ competition and efficiency. Some counterintuitive but significant and valuable conclusions are made. Chapter 6 is about conclusions and policy suggestions. This chapter puts forward some policy suggestions on the development of China’s banking sector based on the research results of the former chapters. Little research on this subject can be found in China. This book seeks to make some innovations in the following aspects after having obtained an indepth understanding of foreign scholars’ research frontier: (1) Studying the macro issues of industrial organization structure in a microscopic manner and collectively studying macro issues with micro data. This book gathers more than 10,000 financial data of banks, accounting for above 85% of the total assets in

14

Introduction

three sample markets and concludes the trend results and policy advice for the entire market. (2) Studying and properly adjusting the foreign mainstream PR model measuring competitive value and the parametric SFA model measuring banks’ efficiency. In the PR model, banks’ operating costs replace manpower input and the statistical test results show that this explaining variable is most stable in the entire model; the measurement of efficiency employs the parametric non-linear approach and the maximum likelihood estimation method in calculation. This method in theory better reveals the intrinsic motivation of evaluating population parameters through samples rather than the least square method and statistic tests showcase that the result is relatively stable. (3) Testing the traditional industrial organization theory through econometrics methods, which draws some anti-traditional conclusions and proves that there is not necessarily a relationship between competition among banks and the number of banks. On top of that, there is no positive correlation between competition and efficiency. (4) Based on the above empirical researches, a comparison of the differences between Taiwan, South Korea and Mainland China in economic environment is made, better explaining the above conclusions, drawing on their experiences and lessons, and coming up with policy suggestions that conform to the development of China’s banking sector.

15

2

Chapter

Literature Review on Banks Competition

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People follow and study how the current merger wave in the financial system worldwide affects competition. This chapter reviews the latest developments in competition, concentration, efficiency and stability from the perspective of the entire environment through a review of the literature on theoretical and empirical research in recent years on the basis of introducing the development landscape of industrial organization theory. When it comes to literature on specific measurement approaches, each chapter will give an introduction when selecting models.

The Development of Competition Theory in Industrial Organization Theory The industrial organization theory system was gradually established and took shape in the U.S. with Harvard University as the center after 1930s. In 1938, Mason started to make empirical studies on the organizational structure, competition behavior and market competition results at Harvard University. Clark published the On Effective Competition Concept in 1940, arguing that the existence of imperfect competition is necessary to make clear the concept of effective competition. The so-called effective competition refers to the competition structure that is conducive to not only upholding competition but also giving play to the role of the economy of scale. Government public policy will become the key instrument in coordinating the relations between the two. In 1959, Bain made in-depth studies on industrial concentration, product differentiation, access barriers and economy of scale among other factors in the formation of the market structure and on the relationship between market structure and market performance, which strongly boosted the development of the industrial organization theory. The Harvard School divides industries into specific markets and measures market relationships in the light of the analytical framework of StructureConduct-Performance (SCP), believing that there is causal relationship between structure, conduct and performance. As such, the most important thing is to adjust and directly improve irrational market structure through public policies to obtain ideal market performance. This theory takes the number of enterprises in the market as the criterion for the improvement ratio of relative efficiency, believing that as the number of businesses increases, market competition will be fiercer and closer to the market condition of full competition, and ideal resources allocation efficiency can basically be realized. In the SCP analytical framework, research on the relationship between the concentration ratio as

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Literature Review on Banks Competition

one of the market structural indicators and the profit margin as one of the market performance standards stays at the core position. The Harvard School argued that in industries with oligopolistic or monopolistic market structure, the machinations between a small number of enterprises and behavior limiting competition via high access barriers, weakened market competitive value which would often result in excess profit and damage the efficiency of resource allocation. Between the late 1950s and early 1960s, the Chicago School of the industrial organization theory developed in argument with the Harvard School. Leading representatives of the Chicago School include Stigler and Demsetz et al. Stigler was awarded the Nobel Prize in economics in 1982 for his pioneering research in industrial organization theory. These economists believed in the role of the competition mechanism in a free market economy in theory and the selfregulatory capability of the market. They represented the thorough economic liberalism of thought. On top of that, they upheld that governments should have minimum intervention in the market competition process, and the power of governments should be confined only to development of the institutional framework conditions for market competition so as to expand the space for and scope of the liberal economic activities of both enterprises and individuals. The theory of Chicago School exerted great influence in anti-monopolistic changes in the 1980s. One of the focuses of the arguments between the Chicago School and Harvard School is that whether the high profits generally existing in the highly concentrated market structure are generated from monopolistic forces or from the high efficiency of large enterprises. The Chicago School argued that the high profits obtained by businesses in a highly concentrated market were only transient phenomena of the market in unbalanced conditions, and that these high profits would disappear as the market became balanced. The Harvard School observed that different market structures resulted in different market performance. But the Chicago School believed that market performance played an underlying role. Different business efficiency shaped different market structures, and the relationship between concentration ratio and profit ratio were unlikely to reflect the behavior of major enterprises in conspiring to push up prices, but rather that they indicated the higher efficiency and lower costs of large-sized enterprises within the highly concentrated industries. As high profits are not generated on the basis of high efficiency operations, a large number of other businesses will make their entry which will quickly downsize profit ratio. The Chicago School thus strongly criticized the SCP analytical framework as they believed that the causal relationship that market structure underlies market

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conduct and then determines market performance did not exist, but rather that market performance or market conduct underlies market structure. The Chicago School pays more attention to judging whether concentration and pricing results have improved efficiency, unlike the structuralism of the Harvard School that only focuses on whether competition is damaged. The key to judging the market conduct of enterprises is not to see whether it undermines or rejects competitors, rather it is to see whether it promotes social and economic efficiency. If there are many competitors in the market, then this will not benefit economy of scale and improvement of economic efficiency, so competition and mergers must be encouraged to boost market concentration. Another contribution of the Chicago School to industrial organization theory study is the analysis of government industrial regulations made by Stigler, Demsetz and Peltzman et al., and this analytical result inaugurated a new research field of economics — regulation economics. The Neo-Austrian School is another influential school supporting industrial organization theory. Leading representatives include Mises and Hayek. The contributions of this school on many theoretical aspects are based on the traditional thinking and approach of the Austrian Economics School created by Menger and Eugen von Bohmbawerk. The Neo-Austrian School stays committed to the logical analysis of individual behavior and focuses on researching stepwise progress analysis rather than on the static general equilibrium that may not exist in effect. They observed that competitive value cannot be measured by standards including concentration or the number of enterprises and market share. Competition derives from entrepreneurship that cannot be taken away by other businesses. In this sense, so long as free access opportunities are guaranteed, the market that is full of entrepreneurship can develop full competition pressure but this has nothing to do with the concentration ratio of the market. Product differentiation is one of the factors affecting monopolistic degree and can be regarded as part and parcel of normal competition procedure. Profits play a key role in the dynamic competition process and guide ready entrepreneurs to constantly allocate resources in a bid to meet the requirements of consumers. High profits are the reward to entrepreneurs for their successful start-ups. Business consolidation represents a tool to facilitate market adjustment and market competition is in itself a process of eliminating low efficiency enterprises. In this connection, they strongly oppose policies on banning consolidation and government intervention. The extreme liberalism thought upheld by the Neo- Austrian School is unrealistic in real economic life. The Theory of Contestable Markets was put forward by the well-known

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Literature Review on Banks Competition

American economists Baumol, Panzar and Willing et al. on the basis of the Chicago School. In December 1981, Baumol first raised the concept of

contestable markets in his inauguration speech as the President of the American

Economic Association. This theory holds that sound market performance including production efficiency and technical efficiency does not need the

existence of numerous competitive enterprises. It can be an oligopoly market and even a monopsony market, and as long as full liberalization of market access is guaranteed and market access and exit costs do not exist, potential competition pressure will force enterprises to engage in competition under any market structural condition. In this circumstance the highly concentrated market structure, including natural monopoly, can coexist with efficiency. Yet competitive market theory centers on analyses of concepts, including the Perfect

Contestable Market and sunk costs to deduce the basic situation of sustainable

and efficient industrial organization and its endogenous forming process. The so-called “Perfect Contestable Market” refers to the fact that enterprises do not

need to shoulder unrecoverable sunk costs when they exit from the market so as

to enter and exit the fully liberalized market. Under the potential competition pressure from the entry of new businesses at any time, the rate of returns on capital generated by the enterprise even it is the only monopsony one in the market will not be more than the normal rate of returns reaped by the large number of enterprises in the Perfect Contestable Market.

The analytical method of the contestable market theoretical basis is similar

to the Chicago School as they employ the Equilibrium Analysis of neoclassical

economics and highlight long-term analyses. The balance realized in the long term means that the entering and exiting process are in static status. That means

that enterprises in the existing market do not have the motivation to exit the market as they have no losses, and potentially competitive enterprises do not

have the motivation to enter the market as the market does not afford high

profits. These two necessary market equilibrium features in the contestable market have led to the following results: (1) All excess profits of enterprises in

the market are zero; (2) The marginal costs of all enterprises are greater than market prices; (3) If there are at least two enterprises in the market, then their

marginal costs are all smaller than market prices; (4) The costs of the total

output volume of existing enterprises in the market is minimum, otherwise new enterprises will enter the market. This demonstrates that the contestable market can realize the optimum welfare target even under oligopoly and monopoly

conditions. It is the potential competition of potential incomers rather than the

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competition of existing enterprises that has maximized the contestable market equilibrium.

The contestable market theory has limitations in terms of the scope of

application and there are few industries that really meet the assumed conditions

of the theory. This theory is not realistic in assuming that the sunk cost is zero, and it is criticized by many economists.

Since the late 1970s, industrial organization theory has changed a lot and

the new research focus has been transferred to the market, where strategic

behavior stays at the core of studying market conduct. Schelling defined strategic behavior for the first time in his book Strategic Conflict . Strategic behavior refers to the expectation of one manufacturer its behavior will impact on its competitor, which can lead the competitor to make decisions benefiting the first manufacturer on the basis of its expectations. This hinges on the inter-

dependent relationship between manufacturers in market policy makings, but this kind of relationship only exists in an oligopoly market structure. Whether

strategic behavior can meet expectations mainly depends on whether it can make a difference in the income expectations generated from different behavior

path of its competing manufacturer. Its affection process is a dynamic competing process, and here we introduce game theory and especially the dynamic non-

cooperative game theory developments that have exceeded the traditional static

framework. Studies of the strategic behavior of manufacturers in the theory

circle are mainly concentrated on how to cut back the number of competitors

in one industry, that is how to squeeze some existing manufacturers out of the market or stop some potential incomers. Spence, Salop and Tirole have reached

important research results in this regard, heralding the development trend of industrial economics. We can learn from observation of the development process of industrial organization theory that there is a close relationship between competition policies and government regulations, and the motivation of

regulations is to correct market failure. The purpose of government regulation

is to safeguard the normal market economic order, increase resource allocation

efficiency, improve social welfare, and promote economic growth. The Capture

Theory (CT) of Stigler1 and the contestable market theory have had profound implications for government policies. As of the 1970s, Western countries have witnessed a strong wave of government regulation reform featuring relaxation

of regulations and involving many key industries and sectors such as electricity and finance.

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Literature Review on Banks Competition

The Optimal Competition Framework of the Banking Industry Northcott (2004) believed that the optimal competition framework should be composed of two aspects due to the characteristics of the banking industry: the first is economic efficiency and the second is financial stability.

Economic efficiency

In the theory of economics, economic efficiency and the welfare landscape of all members in the economy are closely related. Next, we will discuss from the point of view of distribution and production efficiency the implications for the competitive banking system and related market forces. Distribution efficiency The contributions of banks in economic growth lie in the improvement of the effect of capital concentration through credit supply. We discuss it from two aspects, namely the size of credit supply and the distribution efficiency.

Theoretical research a. The competitive market. The external environment of competition is the necessary guarantee for distribution efficiency. As we all know, competition in the financial sector can result in low costs, high efficiency, product innovation and service level improvement of financial intermediaries. In a fully competitive market, competition realizes welfare maximization by providing the largest size of loans at the lowest price. In contrast, in places where market forces exist, banks will cut back on the size of loans while collecting prices higher than marginal costs. Theories about competition in the banking sector come from documents of industrial organization theory. The imperfect competition model is mainly used to illustrate how enterprises pursuing profits maximization utilize market forces to increase profits via limiting output and raising prices. That is to say when there are only a small number of enterprises, the output is below the perfect competition level and the price is higher than the perfect competition level, which will trigger losses to the consumer and producer surplus. On the contrary, when the number of enterprises increases without limit, the market will change to the equilibrium of perfect competition. These theories transplant the theory of the manufacturing industry to the financial service industry and make the same conclusion at the same time — a large number of banks can guarantee competition in the banking sector.

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We can see that even in the standard industrial organization theory framework, the above mentioned viewpoints have limitations. For instance, in Bertrandʼs competition model, only two enterprises may witness perfect competition. If this theory is set up, we would not need tens of thousands of banks to support the equilibrium of perfect competition. At the same time, banks are supposed to be the same as other industries and enterprises. What merit our attention is whether the standard competition model assumption fits the characteristics of the banking industry. Besanko and Thakor (1992) used a theoretical model to test the loan and deposit market. In this market, they designed the model of space based on the characteristics of bank geographical location, which explained the differences of product supply in a broader range and separated itself from other competitors. Before them, Hotelling (1929) and Salop (1979) also used a similar research method for the space model. They found that when more banks enter into the market, the loan interest rate will drop but the deposit interest rate will pick up. Guzman (2000) used a simple general equilibrium model to compare the capital accumulation effect of a monopolistic banking system and a competitive banking system. He discovered: (1) Under the monopolistic banking system, the credit capital of banks is allocated but this is not the case under the competitive conditions. (2) If allocation exists in both systems, monopolistic banks would pay a relatively lower deposit interest rate even if the bank provides the same interest rate for each loan. Research by Smith (1998) showcased that monopolistic banks would also collect higher interest on loans even allocation does not exist. All the above models support the theory that market forces are harmful to consumers and economic growth. Claessens and Laeven (2003b) put competition in the banking industry in 29 countries and the growth of the industry accepting loans together and found that the role of competition depends on the development of the financial system when it comes to enterprises obtaining banking capital. That is to say industries relying heavily on foreign capital 2 grow faster in countries featuring an underdeveloped financial system and lack of competition; but competition and the growth of the banking sector have a positive correlation in countries with a developed financial system.3 In the developing world, governments try to set the interest rate below the market price level and control credit allocation through guiding banking business or holding bank shares due to limited capital resources. They work out a lower ceiling so as to bring down borrowing costs and demand that banks lend capital to key sectors such as agriculture, industry and export. Both domestic and foreign literature suggests that economic performance in many

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Literature Review on Banks Competition

countries is in gloomy way under this system. In countries with distorted or negative actual interest rate, the economic efficiency and performance in general are not as good as those with a relatively lower or positive interest rate. As loanable funds go to inefficient state-owned enterprises, the allocation of credit is inefficient. The upper limit on the interest rate has not only reduced the amount of loanable funds but also resulted in inefficiency of the financial sector. More importantly, financial regulation has weakened the efficiency of credit distribution and the generated rent will more often than not worsen income allocation. The source of production inefficiency is a non-market credit allocation mechanism. This mechanism signifies that some credit will go to projects that must be supported by loans and the low interest rate has fueled capital waste. Meanwhile, projects with high returns were squeezed out and could only raise funds themselves or abandon effective technologies. Prescriptive credit has not only made market-oriented financial institutions lose the motivation to investigate and screen those programs that might bear high risk rewards but has also cut the impetus for banks to examine credit and recover overdue loans. b. Net capital. Capital funds as the internal factor is the basis of allocation efficiency. After the public rollout of Basel Agreement , an important document on commercial banks, regulation of capital adequacy ratio has increasingly become a hard indicator. The capital amount offered by banks is reckoned not only on competitive market structure but also internal factors, such as net capital. The financial accelerator theory 4 points out that the lending model of banks might change their net capital, which will influence credit supply. Abnormal fluctuation in the net capital of banks can spark shrinking loans which will make a difference to growth (Bernanke, Gertler and Gilchrist, 1996). The financial structure of one bank can exert great influence on diversified lending business volume. Banks supply credit funds with liabilities and capital stock and they must meet the requirements stipulated by the Basel Agreement for the lowest capital adequacy ratio (capital/all risk assets). If the proportion of the capital of a bank in the assets drops to a much lower level, then it must replenish the capital funds in one of two ways. One choice is to issue capital stock or decrease dividend allocation. The former means cost while the latter is restricted by the opinions of shareholders and can exert negative influence on the stock prices of banks. The second choice is to reduce risk assets and loans in particular. Even if capital requirement is not a legal claim, the fluctuation of bank stock (i.e. net value or net assets) will also affect loans; similarly, even if there are no bad debts, increase in loans will drive down the capital adequacy ratio. If a bank meets the requirements for the lowest capital adequacy ratio

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or chooses a relatively higher ratio of capital funds for other reasons (e.g. as the signal of a force or a bumper of future fluctuation), it must lower loans in general or allocate a higher ratio of loans to asset items with low risks. c. Technological advancement. Access to and application of advanced technologies can improve the efficiency of distribution. On the one hand, in a market structure lacking competition, banks might be ready to make investment in technologies; on the other hand, technological progress is wellpositioned to level up the overall competition level with other banks and nonfinancial institutions via bringing down the costs of financial services. Some scholars argued that in a market structure with fierce competition, banks tend to make investment in technological advancement in order to keep their market share. Hauswald and Marquez (2003) analyzed the implications of endogenous competition for technological progress, believing that information technologies can enhance information processing efficiency, cut down costs for obtaining information and even provide access to information free of charge. An unrestricted information channel can lower the interest level and the net effect of borrowing and raising funds may transfer with the holistic technological progress and market structure. d. Information asymmetry. Projects or enterprises boasting sound efficiency should have top priority when providing loans, but information asymmetry sometimes may make it difficult for banks to make decisions. That is to say the degree of information communication between businesses and banks can make a great difference in the efficiency of loan allocation. The theory that banks are able to improve capital allocation efficiency is based on the recognition that banks can quickly absorb savings and allocate investment on the one hand and that the generated information can reduce the information asymmetry between creditors and borrowers on the other. Two theories are available in this regard, namely the “debtor-creditor relationship” and the “role of supervision”. First is relational loans and transactional loans. Relational loans focus on establishing a relationship with some specific or individual business. Banks need to spend costs on relationship establishment, but they can reap earnings from the exclusive information gathered through this kind of relationship. The focus of banks is not immediate returns, rather they value the profit flow from future development. Transactional loans belong to the normal or regular loans that evaluate the observable and transparent information of businesses through a credit rating model. It is not based on relationship and suits enterprises with demonstrated profitability and a regulated financial system. Relational loans are most conducive to non-transparent businesses that are new, private or small businesses without a credit record and lacking guarantee mortgage. Transparent

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Literature Review on Banks Competition

and high quality borrowers enjoy a sound credit record, so they can make a choice between relational loans and transactional loans. In early documents, Petersen and Rajan (1995) believed that banks with market power prefer relational loans. Arguably, the proportion of loans offered to new enterprises might be higher. Banks face many borrowers with different risks every day, but new enterprises have special risks. In a competitive market, potential losses brought by high risks may be offset by collecting higher interest. That said, this may attract more clients (adverse selection) and borrowers also have the motivation to engage in high risk businesses (moral hazard). If one bank enjoys market force, higher risks can be offset through sharing future profit flows of the enterprise and banks can gain benefits from loans down the line. In this connection, banks are ready to provide credit and establish longterm relationships initially by means of “subsidized interest rate”. When it comes to theoretical research, many scholars believe that relational loans are incompatible with competition, although some others argue differently. As a case in point, Boot and Thakor (2000) proposed a model, finding that if banks engage in relational loans and transactional loans simultaneously the proportion of relational loans is higher than that of transactional loans in the total loans in a competitive environment. Yafeh and Yosha (2001) made another model, showcasing that competition and transactional loans do not run against each other. They suppose a monopolistic bank provides both relational loans and transactional loans, and the former one is provided to middle and low quality borrowers (including non-transparent borrowers). As borrowers enjoy high value in relational loans, thus they are ready to pay more fees or financing costs and monopolistic banks can generate more profits; for high quality borrowers, banks typically offer transactional loans; when bank competition gets fierce, profits obtained from relational loans may contract. The research results of Petersen and Rajan (1995) show that competition makes profits in transactional loans drop more sharply than that in relational loans, which has driven banks to choose relational loans. Second is inspection and supervision. Bank inspection of loans is to reduce the important channels of information asymmetry. Cetorelli and Perotti (2000) proposed an “inspection” variable. They put this variable into models and developed and enriched the method of testing the optimal competition structure of the general equilibrium model with accumulation of capital. Banks have motivation to inspect borrowers with the aim of distinguishing high quality borrowers and low quality ones. Having said that, inspections need costs and banks as competitors can easily get inspection results freely, which reduces their inspection motivation. Their studies embody that the best strategy is

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to provide funds to both “safe” fund raisers (who have been checked) and “risky” borrowers (who have not been checked) as part of the effort to reduce the proportion of banks getting information free of charge. But they only make sample checks. The proportion of “safe” and high quality loans will increase if banks have more motivation to check borrowers. Monopolists have motivation to make checks on loan quality as they have collected higher interest charges and need to prevent and lower potential risks. The more concentrated the bank is, the more motivation they have to make checks as their profits come from “exclusive” information (Guzman, 2000). When the number of banks drops, banks would weigh credit amount and quality of borrowers (i.e. capital allocation efficiency), and this weight will take a heavy toll on economic growth. Dellʼariccia (2000) pointed out that the motivation of banks to check loans will drop as they grow in number.

Empirical tests Within the framework of traditional industrial organization theory, market force triggers a higher loan interest rate and a lower credit supply, which has had negative impact on economic growth. At the same time, some scholars also observe that market force is well-placed to improve the functions of information products of banks (through the relationship of loans and inspection), which will be conducive to the efficiency of capital allocation. When testing and verifying these theories, documents on experiences mainly use bank amount or the concentration ratio of the banking industry as indicators for market force. Most literature in the early days used data from the U.S. to test the relationship between bank profits (or prices) and competition. For example, Berger and Hannan (1989) believed that concentration is connected with low deposit interest rate and Hannan (1991) found that the increase in concentration is related to high loan interest rate. Indeed, early studies show that concentration and profits have a positive correlation and this supported the view that market force does no good in allocation efficiency and then drew the conclusion that it is not conducive to economic growth. Most studies failed to take into account the differences in production efficiency, that is, the differences in operational efficiency between banks. A highly efficient bank should enjoy high profits due to its strong points in maximizing income. Its success could increase concentration as it can naturally obtain a larger market share or take over banks with difficulties and losses using its success as a platform, and thus concentration and high profit are related to each other. If we take into consideration the differences in production

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efficiency of banks and make adjustments in the model variables, Berger (1995) found that the result is mixed. Although he found that market share and profit have a positive correlation when the efficiency is under control, concentrated banks usually have a negative correlation with profit so that concentration does not necessarily mean market share. Punt and Van Rooji (2001) made a similar study of the banking industry in Europe and came to a similar and mixed conclusion. Their empirical studies supported the positive correlation between concentration and profit but failed to fully support the profit availability under different circumstances. Petersen and Rajan (1995) used data from the U.S. to test their theory of credit relations. Taking concentration as the indicator for market power they found that new businesses can easily obtain credit support in a concentrated market compared with other enterprises in a bank market lacking concentration; they also found that borrowers could utilize the development cycle of enterprises to smooth the interest rate in a concentrated market and that businesses are required to pay lower interest during their startup period but higher interest after they become mature. In recent years, many scholars have used panel data to test the efficiency of concentration in a broader range of the financial sector. Cetorelli and Gambera (2001) used multinational and multi-industrial data to test the implications of the average efficiency of bank concentration for its growth in different industries. They found that the negative correlation of the impact of concentration on growth is clear-cut, but the degree of implication differs for different enterprises. In businesses that heavily depend on exogenous capital5 (such as banks) and have more new enterprises, banks grow faster in countries with a higher concentration ratio, which has given support to the theory of relational loans (Cetorelli, 2004). Corvoisier and Gropp (2002) chose data of European nations to test the relationship between concentration and prices for loans that can be affected by competition conditions, cost structure and risks among others. They found that different bank products (loans, demand, savings and fixed term deposits) can be differently affected by concentration. Beck, Demirguc-Kunt and Maksimovic (2004) used data of both developed and developing countries to test the implications of concentration for credit availability of banks. Credit availability may be limited by national regulations, such as access, structure of ownership (stock rights) and the business activities of banks. They found that businesses are facing higher capital obstacles in a concentrated market. For the developing countries, with the improvement of opening up and the legal system, different factors will decrease over time.

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The reduction of corruption, a developed financial system, and economic development and the access of foreign-invested banks will make it easier to generate convenience. Their studies found that this implication is insignificant for the highly developed financial system. Demirguc-Kunt, Laeven and Levine (2003) checked the impact of different policies and regulations on net interest profits. These policies and regulations include access, changes in banking business activities and limitation of new banks. They found that changes in each project will make a difference in earnings on net interest and even reverse the negative impact of concentration. Studies showcase that evidence of the positive correlations between concentration and profits are insufficient. Early research found that concentration and profits had positive correlations, but the results cannot be tested by time, bank products or profit details. Recent studies demonstrate that control factors in efficiency, such as differences between banks and in the competition environment (such as access obstacles) can make a difference (and even eliminate) the positive correlations between competition and profit. Production efficiency 6

Theoretical research A single economy should have Pareto Efficiency and its production must be efficient. That is if it does not reduce the output of some products, other products would not be produced. Pareto Efficiency demands that the economy operate along the production possibility curve. Along this curve, the only channel to increase the output of one kind of product is to cut down the output of another kind of product. When output is produced with the lowest costs, then production efficiency (or cost efficiency) can be realized. The two channels for banks to make production efficiency a reality are economy of scale and competition. Over the years, people have remained divided over economy of scale in the banking sector. Generally speaking, as technology-intensive businesses, banks can cut back on costs through the expansion of scale. Thus many people believe that economy of scale exists in the banking sector in some sense. Only a small number of large enterprises existing in the market can demonstrate its market force. In the event that economy of scale exists in the banking industry, then efficiency is obtained through scale. If economy of scale does not exist, then a perfect competitive market is the most critical factor for generating maximum production efficiency. If economy of scale exists, the improvement of production efficiency depends on large banks and more concentration, and this echoes the viewpoint of market force in industrial organization theory.

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Literature Review on Banks Competition

Empirical results Research on bank efficiency focuses mainly on the following issues: (1) scale

efficiency, range efficiency and X-efficiency issues; (2) resources utilization effect of the banking sector; (3) ranking of bank efficiency; (4) factors that can make a difference in efficiency and issues of how to improve and increase these.

Early empirical studies on the capacity of bank economy of scale were mainly

concentrated on the banking sector of the U.S. It is widely recognized that

medium-scale banks have most economies of scale, indicating that the economy of scale exists there. The mainstream opinion is that the average cost curve is

the relatively smooth U-shape and the most efficient scale is at the lowest point

of the average cost curve. For small banks, there is the trend of economy of scale, but with the expansion of the bank scale the average cost might drop over time. The average cost of large-sized banks remains unchanged or demonstrates diseconomies of scale to some extent. They have some strong points in saving

costs compared with their smaller counterparts, but their capability to make profits is inferior to smaller ones. Different studies reach different conclusions,

but medium-sized banks (with assets of between USD500 million and USD1.5 billion) are universally regarded as the most efficient ones (Gehrig

and Sheldon, 1999). After the 1990s, with the growing economic aggregate

and dramatic changes in the economic environment, banks with efficiency have continued to expand. Berger and Mester (1997) studied the data of 6,000

banks in the U.S. between 1990 and 1995 and found that economy of scale with

potential costs exists when they enjoy assets of between USD10 billion and USD25 billion. Recent studies by Hughes, Mester and Moon (2001) concluded that when the risk bearing behavior of banks changes, the economic scale of large banks will be limited.

When it comes to the measurement of bank efficiency, one widely applied

method is X-efficiency, that is to calculate the correlation in efficiency between one bank and other banks when the input and output factors and prices are

preset. Calculating the optimal cost boundary (also known as the frontier) is widely recognized by an industry, but the measurement of bank efficiency

of some banks is to recognize its distance from the boundary, and the longer distance it has more inefficient the bank may be.

There are two approaches to measurement of frontier efficiency value,

namely parametric and non-parametric ones. The results are different in some

way as these two are different in definition and research method. Relatively speaking, the non-parametric method (typically represented by DEA) has

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relatively mature software and is easy and convenient to employ, but this

approach has some drawbacks that will be explained in detail in Chapter 4. The parametric method is in theory more precise. Berger and Humphrey (1997) found after analyzing 122 pieces of information about studies of the efficiency of

deposit financial institutions that 69 researches had employed a non-parametric

model, of which 62 used the DEA method; 60 studies used a parametric model (some of which employed more than two methods), among which 24 utilized

the SFA method, 20 adopted the DFA model and 16 employed the TFA method.

It is clear that the choice of model is related to the perspective and focus of the research, so we cannot say which method is optimum. People continuously

adjust variables and there are some drawbacks based on the characteristics of the study sample in the empirical test. For instance, they may introduce a more

flexible production function mode in the parametric method, such as the Fourier trigonometric function in logarithmic function (Altunbas et al, 2001),7 making

it more accurate in description of the actual situation; and they may introduce random error in the non-parametric method so as to offset the limitation in this regard.

Studies of the X-efficiency of the banking industry conclude that a large

number of banks suffer from cost inefficiency. One common research result is

that banks have about 20% inefficiency costs on average, 8 which means that if a bank can realize the most efficient target within the system then it only needs to spend 80% of the cost. Virtually all literature concludes that bank

X-efficiency is far greater than the efficiency of the size and scope. Carbo,

Gardener and Williams (2002) found that European saving banks can only save 7–8% of costs by increasing scale efficiency while X-inefficiency is as much as 22%, illustrating that costs can be cut or output can be increased by a large

market through internal operation management. Some research has tried to explain the causes behind the differences in efficiency between banks, such as

bank size, organizational form, market features (such as concentration) and the implications of some specific variables of banks (such as the year and the proportion of loans in assets and so on), but the research results are mixed.

The efficiency of bank scope includes the efficiency brought by product

diversity and the efficiency brought by regional expansion. Studies by Berger and Humphrey (1994) embody that the efficiency of bank scope is quite limited and producing diversified products can only cut back on the costs by 5% or so, but it showcases the feature that earnings are not affected by product diversity.

The internal factors affecting bank efficiency mainly refer to the management

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level of the bank. External environmental factors include technology

(information technology in particular), competition and the relaxation of financial regulation (including the extension of business scope). Harker

and Zenios (2000) divided the factors driving the performance of financial institutions into three levels, namely strategy, strategy implementation and

environment. Of which strategy includes selection of product mix, customer

portfolio, geographical location, allocation channel and institutional form; strategy implementation refers to the factors that might affect the performance

including X-efficiency, human resources management, technology application, process design and the integration of the latter three; environmental factors

include technology, consumers’ attempts to change (e.g. asset portfolios

gradually change from simple deposit into diversified product mix and the financial management of experts) and changes of financial regulation.

Frei, Harker and Hunter (2000) believed that the selection of financial

institutions for human resources, technology and process regulation models

and the implications for financial service quality, cost and convenience degree are driving forces for the efficiency of financial institutions. They noted that economy of scale and range cannot explain the driving force for efficiency

at the company level and there is no management practice, capital output

and corporate strategy mix can ensure success. Only effective integration of

technology, human resources, process management and capital input under appropriate production “technology” holds the key to the improvement of the efficiency of banks.

Some evidence shows that competition behavior has a specific relationship

with high efficiency. The empirical study by Angelini and Ceterelli (2000)

showcases that the banking industry of Italy has become more competitive after it deregulated banks in 1993; Schure and Wagenvoort (1999) also found that

Italian banks have witnessed significant improvement in X-efficiency after 1993.

Evanoff and Ors (2002) found that the enhancement of competition intensity (using access increase or cultivation of more competitors to measure) is related to high X-efficiency in the American banking sector. Weill (2004) has carried

out an empirical test on the relationship between competition and efficiency for banks in EU from 1994 to 1999, and found a negative correlation between them.9

There is still no conclusion on whether inefficiency results from the shortage

of competition in the market (or excess competition) or because there is no realized economy of scale, or if the two factors coexist.

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Financial stability Theoretical study It has always been our view that market force is the necessary guarantee for the stability of the banking industry. Profits and sufficient capital funds can put banks in a strong position to hedge against the negative impact of fluctuations brought by balance sheet. As such, banks boasting market power enjoy better sources of profits and meanwhile sound credibility and strength, and banks are regarded as the stabilizer of finance. Fluctuation suffered by banks might in part be the result of their risky behavior. The theory of high quality financial structure observes that financial leverage10 businesses have motivation to engage in venture business and banks as intermediary credit institutions in particular. If their venture succeeds, shareholders gain profits; if it fails, borrowers bear the costs (Jensen and Meckling, 1976). Many undertakers of debts are middle and low income savers. They are individuals and have sound access to information about the business and potential risks of banks; yet the existence of deposit insurance has reduced the motivation of savers to monitor banks engaging in venture businesses. It is generally believed that large banks enjoying market force have motivation to minimize their venture behaviors (charter value theory) so as to level up their asset quality (test theory). That said, the conclusion is not that straightforward. Competition between investors and fund raisers in the financial market has a positive role in stability and can guarantee the spread of risk. Competition also guarantees the actuality and effectiveness of information; as such, the price of assets is precisely set by the supply-demand relations. These prices have effectively signaled resources cultivation.

Charter value 11 In early documents, Keeley (1990) believed that the growing number of bankrupt banks in the U.S. in the 1980s was partly because of the intensifying competition in the banking industry. His main argument is that charter value is related to venture behavior. Charter value comes from the profit increase obtained from future operations of the owner of a bank and it represents the opportunity cost of bankruptcy. When deciding venture behavior, banks must weigh up proceeds from their venture behavior and losses of charter value if they end up in failure. Keeley argued that a bank enjoying market power has higher charter value as it has higher rent, so the opportunity cost of going

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Literature Review on Banks Competition

under is high, which may prevent it engaging in venture business. The opposite argument is that the bank is too large and cannot go under water . For most banks, part of the debt is assumed by deposit insurance, which has encouraged them to engage in venture business. If they fail, debtors and shareholders would bear on losses without insurance. As bankruptcy will bring serious results, it is typically believed that regulators would not allow a mega-bank to go bankrupt as the potential costs of the chain effect would be even more than government expenditure on assistance. This is in essence a strong protector for high liabilities of banks. As such, banks have motivation to become involved in venture business. The intensifying competition will result in the drop of charter value on the one hand and add to risks on the other. Besanko and Thakor (1993) believe that charter value comes from a unified market including the exclusive information obtained from relational loans. Perotti and Suarez (2002) noted that when policies of regulators encourage a full-fledged bank to take over a closed bank, this bank (the full-fledged) enjoys high rent and the charter value will increase accordingly. As a matter of fact, any factor for increasing bankruptcy possibilities is bound to be connected with charter value. Hellman, Murdock and Stiglitz (2000) inspected charter value in the environment with capital adequacy ratio demand. The higher the requirement for core capital and supplementary capital is, the more losses the shareholder will suffer. That is to say that higher capital requirement may reduce the venture motivation of banks, venture may increase the losses of stakeholders, and the more capital they enjoy, the more losses they will have. Hellman, Murdock and Stiglitz adopted a dynamic model and found that banks will have motivation to increase saving rate to boost market share in a competitive market so long as the interest rate is freely determined during the process of competing for saving deposits. This has corroded profits, cut back charter value and added to risk degree. Repullo (2004) expanded his model through simulating competition in the saving market and banks are able to make investment in venture assets and prudent assets alike. Repullo’s study embodies that both the venture business market and the prudent business market can realize a balance for a middle level market. He also testifies that prudent balance is superior in the environment with capital demand. Sanoders and Wilson (2001) believe that charter value arises from the highrisk business of banks. That is to say that minimizing risk activities will have impact on charter value. During a period of economic expansion, the charter value of banks provides many opportunities for their growth i.e. banks with high charter value have easier access to the share capital needed for expansion. During this period, charter value and capital adequacy ratio have positive

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correlations. But during a period of economic contraction this relationship would be reversed i.e. negative correlations. Results of panel data regression illustrate that the relationship between charter value and banking capital are sensitive to market conditions.

Infectious disease effects Suppose a bank goes bankrupt. An important issue that merits our attention is whether the holistic financial system can recover from the fluctuation quickly. Infectious disease is defined as: the risk that vibrancy of credit or liquidity will lead to the vibrancy of other trade actors in nature for financial system. The important channel of infection is the direct relationship between actors and the inter-bank network system is the major transmission channel. This network involves both the inter-bank market (short- and medium-term) and the linking channel between payment system and derivative financial products, among others. They can make a difference in the time it takes for the overall system to recover from fluctuation. Allen and Gale (2000b) made an infection examination of the holistic banking system. Regional banks and inter-bank savings are linked together in this system. Liquidity risks in one region can be transmitted to other regions through the saving network and the spread of infectious disease depends on the inter-bank network. A “modernized” market structure means that each bank has network relationships with its surrounding counterparts. Another critical factor is economic “connectivity”, which means that regional and economic sector extensions are inter-connected and inter-linked. Allen and Gale found: (1) in a market with a sound financial system, the implications of fluctuation is transmission among all other banks and each bank would reduce vibrancy costs and degree and transfer it to other regions during the transmission process. Infectious disease would happen again, but it would not be more serious and stronger than that in a poor market. In addition, the impact on each bank will decrease, fluctuation will be weaker and the infection effects will drop with the increase in the infected bank numbers and regions. (2) In an unsound market, the implications of fluctuation will be assumed only by a few banks. That is to say the bank cannot absorb the vibrancy, so the vibrancy will continue to spread at the same amplitude. An unsound market structure is more sensitive to infections and the effect is just the opposite to that in a sound market with the growing spread of bank numbers and regions. As infections spread to surrounding regions, the overflow effect increases, and it is easy for infections to continue to spread and be transmitted. (3) The integration of an

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Literature Review on Banks Competition

unsound market and a highly connected market structure is most likely to see the rise of the infection effect. All in all, it’s not clear which kind of inter-bank relationship model can influence the competition structure of the banking system. A large number of banks are well-positioned to decrease infection risks, but the premise is that their connection must be sound and inter-linked. At the same time, a unified system with only a few banks may be more likely to maintain this connectivity.

Screening and supervision We have discussed the role of supervision and inspection in allocation above and the conclusion is to check the improvement of loan quality of banks, and that banks with market power have more motivation to monitor loans. With an increase in the number of banks, even if the inspection motivation remains unchanged, many banks would be exposed to or suffer from risks as long as the inspection technology is imperfect or has drawbacks. Shaffer (1998) described a market of this kind. Here, bank loans are only offered to borrowers whose technologies are being regarded as “strong”. Of course, each bank may have loopholes of this or that kind. A borrower which is turned down can continue to apply for loans from other banks in the market, but the other banks do not know that the borrower has been turned down. Generally speaking, the applicant being refused is more likely to be a borrower of poor quality. Shaffer pointed out that the number of loans increases with the growing number of banks, and more banks would decrease the possibility of obtaining loans (including borrowers of poor quality). As such, the expected loan losses are an increasing function of bank numbers. Of course many measures can downsize this kind of losses. A bank may have access to information that a borrower has been turned down by other banks or that the borrower is not creditworthy through inquiring with credit-standing related departments.12 A large amount of bank loans flow to low quality borrowers, which will result in the deterioration of the quality of bank loans. Supervision and regulation may play a key role in containing this trend. Cordella and Yeyati (2002) investigated the implications of competition for the motivation of supervision and regulation. As with former studies, they found that market competition will lead to the contraction of input in investigation and supervision. The above mentioned problems can be reduced if banks disclose information about loan business risks, but information disclosure is expected to increase the risk costs of banks and information disclosure to the public can add

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to the pressure for and motivation of supervision. As the increase in business risk will make depositors demand higher deposit interest rate (that can be regarded as another kind of punishment on banks), this will add to the costs of banks. The operation of deposit insurance with risk as the basis is quite similar to the practice of differential rates and the link between of rate and risk degree, so more risk means higher rate of fees paid by banks. Cordella and Yeyati believe that both public disclosure and deposit insurance (rate) with risks as the basis can reduce the influence of competition. Empirical evidence Are banks exposed to higher risks in a competitive market? In the late 19th century and early 20th century, the financial system of the U.S. frequently witnessed crises. But this was not the case in Europe after the mid-19th century. Intervention technologies of the central banks of Europe and the central bank of England in particular were quite mature and crises were basically eliminated. Keeley (1990) observed when studying bank holding companies in the U.S. in the 1990s that the bankruptcy of American banks in the 1980s was partly due to the increase in competition as competition corroded monopolistic profits and charter value and the decrease of charter value added to the motivation of banks to engage in venture business. Keeley also found that charter value has positive correlations with the capital of banks and negative correlations with bank risks (being demonstrated by the fact that banks must pay risk premiums). Demsetz, Saidenberg and Strahan (1996) also found on the basis of Keeley’s study that higher charter value is related to higher level of capital and lower level of risk. Salas and Saurina (2003) employed a similar method on the banking system of Spain and concluded that higher charter value is closely related to lower level of credit risks. De Nicolo (2000) examined the relationship between charter value and the scale of banks. Generally speaking, larger banks means higher market value, thus the correlations between charter value and bank scale should be positive. De Nicolo found that the enlarging scale is related to bankruptcy risks. In general, higher charter value means more motivation for banks to engage in prudent businesses and the risks of bankruptcy will be downsized. Beck, Demirguc-Kunt and Levine (2003) researched the panel data of 69 countries between 1980 and 1997. They found that bank crises 13 rarely happen in the following circumstances: (1) in a more concentrated banking system; (2) in a fiercely competitive banking system that has few limitations on business activities and the country has a relatively strong legal system. That is to say

38

Literature Review on Banks Competition

both concentration and competition promote stability. The authors tried to conclude whether concentration can boost diversified operation and contribute to supervision and regulation, but did not find an inevitable relationship.14 They noted that there was no evidence to show that a concentrated banking system is more easily supervised and regulated than a decentralized one.

Summary of arguments over efficiency and stability The best state weighing efficiency and stability should meet three requirements, namely highly efficient banks, promoting economic growth, and a stable economic and financial environment. Market power is the necessary condition for stability. At the moment, theoretical studies remain divided over whether perfect competition and market force enhance allocation efficiency. (1) In traditional industrial organization theory, perfect competition can provide the most credit at the lowest price and market force results in shrinking of the credit supply and higher prices. (2) As long as asymmetry of information exists, banks will have the motivation to develop relational loans with clients to expand market force, which is conducive to non-transparent borrowers (such as the new enterprises without credit history or collateral). (3) The top priority of banks in offering loans is given to projects or enterprises with high quality and high returns; checks can enhance the allocation efficiency of loans; monopolistic banks have motivation to supervise and check loans and their motivation drops with an increase in the number of banks. (4) Conflicts might exist between competition policy and financial stability. Much empirical literature focuses on the relationship between concentration (as the indicator for market power) and profit. Some studies have found that concentration is indeed related to high profits; with the development and opening up of the financial system, such as lowering the access threshold and reducing limitations on business activities of banks, among others, market power will be demonstrated more obviously. There are not so many documents about empirical research or theoretical examinations on relational loans. Some studies indicate that non-transparent borrowers can benefit from banks with some degree of market power, but people remain divided over whether this can improve the allocation efficiency of the holistic loans so as to promote macro-economic growth. In general, the concentration of banks is not a good indicator for the measurement of the competition environment, but undoubtedly a competitive

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environment is conducive to the improvement of allocation efficiency. Banks with some degree of market power can increase the supply of credit funds and play a bigger role in credit allocation efficiency compared with improving motivation of monitoring loans. Production efficiency is realized through maximizing competition in line with the traditional framework of industrial organization theory and banks have economy of scale to some extent. Empirical research demonstrates that the banking industry now suffers from production inefficiency, but it is not clear whether this is the result of the shortage of competition or the absence of economy of scale. For that matter, some research on allocation efficiency showcases that competition and concentration can coexist in one market. If this conclusion is established, it is totally possible to reap benefits from both competition and economy of scale. Is market force the necessary condition for stability? Charter value theory holds that higher charter value can reduce the motivation of banks to engage in venture business through adding to the possibilities of bankruptcy costs. In traditional theory, market power is connected with higher charter value and any factor that may increase opportunistic cost leading to the bankruptcy of banks will cut back charter value. It is tempting to say that the most sensible choice for risk reduction is to increase the capital adequacy ratio no matter what the competition structure of the market is. In terms of examination, theoretical documents conclude that banks with market power have stronger motivation to monitor loans, which will level up the quality of credit business of banks. In the meantime, measures to strengthening information transparency of banks in venture business or demanding a deposit premium rate based on risks can facilitate the stable operation of banks. Market force can drive banks to be prudent, and policy and regulation adjustment (such as the requirements for capital adequacy ratio, regulations on information disclosure and collection of deposit insurance rate based on risks) can also make banks prudent and stable in operations even in a very competitive market. Some recent studies show that crises of the banking industry are unlikely to occur in a competitive and concentrated banking system. Should efficiency or stability be given top priority when choosing a market structure? The existing literature remains divided over this issue. Competition holds the key to efficiency, but market power also plays a part as it gives a strong boost to banks to be prudent, and government policies and regulations can also guarantee that banks are careful of their code of conduct in a competitive market. For the banking sector, we can choose neither extreme

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Literature Review on Banks Competition

competition (perfect competition) nor monopoly. Monopolistic competition in between the two is more suitable for the characteristics of the banking industry in terms of both idealistic and realistic choices. Perfect competition is less likely to occur in the banking industry than in other industries. The standard assumption of industrial organization theories that fit general industries such as qualitative products, free entry and exit (the feature is that the sunk cost is zero) are not applicable to the banking industry. It is thus not realistic for the banking sector to eliminate market force. In short, government targets are not to eliminate market force but rather to optimize and improve the competition environment. In this connection, potential adverse effects brought by market force will decrease over time.

Characteristics of the Competitive Banking Industry Let us explore different ways to assess competition between banks and study the characteristics of a competitive banking sector. Northcott (2004) noted that the banking sector has two features, namely concentration and competitive value.

Concentration The concept of traditional competition is linked with the number of enterprises in the market i.e. there are many businesses in the market. These businesses are in fierce price competition, and fewer enterprises means less competition. This comes from the paradigm of traditional industrial organization theory that is SCP. This theory was initially put forward and developed by Mason (1939) and Bain (1951). It supposes that there is a causal relationship between structure, behavior and performance. Market structure affects the price behavior of enterprises, which determines the degree of market profits and market force. As price behavior is not easily observed, most literature establishes a relationship between market structure and market force. Typical structural variables are concentration and the amount of sellers while market force is measured with financial data of profits and costs. For a long time this research mode was mainly based on industrial data and many studies employ this kind of paradigm for a specific industry and testify the positive correlations between concentration and profit in theory after time. There are many difficulties and problems in applying the SCP method to the banking industry. The earliest challenger of SCP theory is effective structure (ES or ESH) theory. ES theory was put forward by Demsetz (1974) and Peltzman (1997). The outstanding behavior of market bellwethers (as a result

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of specific factors such as high level of technology and management etc.) will endogenously determine market structure, which means that higher efficiency may bring about higher concentration and profits as well. Enterprises with higher production efficiency enjoy lower costs, and thus higher profits. These enterprises wish to grow and thrive in both size and strength which will result in concentration. The positive relationship between concentration and profit is not the result of market power but rather the result of the fact that efficient enterprises boast a larger market share. In this sense, concentration is the reflection of efficient banks but not necessary the enhancement of market power. Church and Ware (2000) criticized the traditional SCP method as financial data on profits are not well-positioned to accurately measure economic profits and market force. From the theoretical perspective, measuring the competition conditions and concentration ratio of the banking sector should first and foremost strictly define the market, and related markets include all suppliers of the banking service sector, including realistic or potential competitors and the geographic scope of products. The definition of product market is based on the capacity to meet the needs of clients and all alternative products should be included in the product market definition, especially many unique alternative products available for the banking industry; the limits of market territory is determined by the connection between actual and potential market actors. At the same time, with the widespread application of bank electronic technologies, the service range of banks has developed from tangible retail sales and counter into intangible space development and it is rather difficult to define the related geographical and spatial markets (local, national and international). Most of the early studies employed American data to test the relationship between profit and concentration. These studies usually realized the expected and rational results. Some later research (such as that of Berger and Hannan, 1998) drew unexpected conclusions. Berger (1995) tried to distinguish the SCP and ES hypotheses through the measurement of X-efficiency and also came up with mixed results. First, concentration is negatively correlated to profit which supports the market share theory. Second, higher efficiency and higher profits are inter-connected, but the relationship between high efficiency and high concentration is rather weak. This only provided partial and limited support for the ES hypothesis. The empirical results on the relationship between concentration and profit are not definitive. Shaffer (2002) integrated the SCP hypothesis with the asymmetric information theory and came up with an interesting theory in terms of risk examination effects. With the growing number of banks in the market, market force will decrease and loan interest rate will drop according to the

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Literature Review on Banks Competition

prediction of the SCP hypothesis. That said, the examination theory pointed out that with the rising bank numbers, the motivation of banks to monitor loans will decrease and risks will increase. Banks will make adjustments through demanding higher interest when facing high risks. As such, conflicting pressures will occur in the loan interest rate as banks grow in number. Which will be superior depends on which is stronger between market force and the asymmetric information effect. According to Schumpeter theory, a certain degree of monopoly can help to enhance the capability of enterprises and encourage them to invest in new technologies. For that matter, a weighting exists between only requiring the dynamic efficiency of a small number of banks and the static efficiency of a large number of banks. The practices of a host of national banks prove that the competition efficiency realized by containing bank scale is probably rather smaller than the costs resulting from the bankruptcy of banks. Small banks have more motivation and opportunity to engage in venture business. In a system with numerous small banks, regulation and monitoring problems are also salient and larger banks are stronger in spreading risks and enjoy more channels in this regard. All in all, it’s not easy to describe the features of competitive behavior independently and accurately, which means that the relationship between the two is not a simple one-to-one correspondence.

Competitive value Measurement approach At present, in the industrial organization theory measuring competitive value of the financial industry, literature about competitive value has gained the upper hand. One statement in papers describing competitive value is that fierce competition may emerge in a rather concentrated market; and on the contrary, inter-business conspiracy can also happen in circumstances where there are numerous enterprises.15 Two methods are available to measure competitive value in the broader sense: the structural method and the non-structural method. The structural method refers to the SCP and ES paradigms and the most common method to measure concentration is concentration ratio (CR n for short) and the HerfindahlHirschman index (HHI). As previously mentioned, use of the structural method for the banking sector has met more and more challenges in recent years. With the continuous innovation and development of industrial organization theory,

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the non-structural model of imperfect competitive markets internalizes market structure and the designed model is more accurate. There are three types of non-structural model: (1) the Iwata (1974) model; (2) the Bresnahan (1982) and Lau (1982) (BL) model; (3) and the PR model (1987). Empirical research in recent years has mainly employed the non-structural method, which is to draw conclusions through studying the competition of banks rather than through analyzing market structure. Of these three models, the Iwata model lacks the micro-data needed for empirical estimation and has never been applied to the banking sector. The other two models have been widely used to measure competitive value. These two methods have not clearly employed information on market structure, but rather they measure the competitive value of banks via estimating the deviation degree of competitive price. During the deduction process of the BL and PR models, the basic conditions of competitive supply in micro-economics are employed. In a perfect competitive market, producers determine to produce one more unit or one less unit of product. We only need to make a comparison of the marginal income obtained from producing one unit product and the costs for producing this unit of product. The former is the market price of commodities while the later is marginal costs. As long as marginal income exceeds marginal costs, more production means more profits. If marginal income is less than marginal costs, then one unit more of production will cut back on profits and manufacturers will decrease production. In general, the manufacturers will define output within the point that marginal costs equal marginal income; in a perfect competitive market, marginal income equals prices. The marginal cost curve of producers is the same as the supply curve. The marginal cost curve suggests the increased costs of each unit output at different levels of production. When it comes to the output chosen by a competitive manufacturer, the costs for producing an additional unit of product equals the market level price, and when prices equal marginal costs this is also the output level of profit maximization. In the BL model, for the balanced enterprise with profit maximization, marginal costs equal marginal income which underlies the prices and amount of products. In a perfect competitive market, marginal income equals demand price (called marginal cost); in the circumstances of full conspiracy (monopoly), marginal income does not equal demand. Testing statistical value λ represents the derivative degree of marginal cost price of enterprises. If λ=0, businesses are in perfect competition; if λ=1, enterprises are in a conspiracy state based on industrial marginal income curve; if the value of λ is between 1 and 0, this reflects the imperfect competition that is monopolistic competition. This model applies to holistic industrial data.

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Literature Review on Banks Competition

In the PR model, changes of input prices are reflected by the income of banks (balanced), that is banks will define different pricing according to input costs determined by different market structures. In perfect competition, the increase of input price will simultaneously pick up marginal costs and the total income with the elevation of costs. In a monopolistic state, input price improvement will add to marginal costs, downsize balanced output and ultimately decrease the total income. Empirical results Shaffer (1989) was one of the pioneers who employed the BL model. He took American samples as the study objects and found that the banking market of the U.S. was not a perfect competition. Shaffer (1993) used the same model to test the competitive value of the banking market of Canada between 1965 and 1989 and found that the calculation results showed that the banking sector in Canada was competitive even though it was relatively concentrated. Gruben and McComb (2003) utilized the BL model to study the Mexican banking sector and found that it was highly competitive and that marginal price was lower than marginal cost in the run up to the financial crisis which hit Mexico in 1995.16 More scholars have employed the PR model to carry out research. Some foreign scholars have employed this method to measure competition in different countries and the results are as below (see Table 2.1). We can see that the banking sector in most countries is a monopolistic competitive environment and tends to be an oligopoly in terms of banking characteristics according to the Bain standard.17 Bikker and Haaf (2002) used the PR model to test the competition behavior of 23 industrialized countries. The results show that they are all in monopolistic competition. This is the typical result of competitive value research and demonstrates the features of the banking sector in most countries. At the same time, they also found that the competitive value is rather weak in the local market but fiercer in the international market. The results of Table 2.2 were selected from the situations in these countries in 1997. Based on the measurement results, the Netherlands is both the most concentrated and the most fiercely competitive country. Some scholars used these models to study the banking sector in both developing countries and countries undergoing economic transformation. Belaisch (2003) used the PR method to test the Brazilian banking industry and concluded that the market structure is non-monopolistic. Gelos and Roldos

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Table 2.1.

Research results of the foreign academic community on competitive value in the banking industry

Dissertation author

Paper presentation time

Time span for sample research

Studying countries

Research results

Nathan and Neave

1989

1982–1984

Canada

Monopolistic competition

Vesala

1995

1985–1992

Finland

Monopolistic competition in most time (except two years only)

Hondroyiannis et al

1999

1993–1995

Greece

Monopolistic competition Large banks: All countries are monopolistic competition. Small banks: Italy is monopolistic competition while France and Germany are monopoly

De Bandt and Davis

2000

1992–1996

America, France, Germany and Italy

Hempell

2002

1993–1998

Germany

Monopolistic competition

Buchs and Mathisen

2004

1996–2001

Eight African countries

Cote d’Ivoire is monopoly while the other seven countries are monopolistic competition.

Yeyati and Micco

2003

1993–2002

Eight Latin American Monopolistic competition countries

Casu and Girardone

2006

1997–2003

15 EU countries

Table 2.2.

Monopolistic competition

H-statistics of the banking market of the selected countries in 1997 Number of banks Market share of the three in samples largest banks (CR3)

Country

H-statistics competition degree*

Australia

0.57

31

0.57

Canada

0.62

44

0.54

The Netherlands

0.95

45

0.78

UK

0.64

186

0.34

U.S.

0.56

717

0.15

* Larger H means a high degree of competition. Source: Bikker and Haaf (2002).

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Literature Review on Banks Competition

(2002) settled for the PR method and selected samples of eight European and Latin American countries. The report results held that concentration ratio kept increasing and the banking market of all the countries became more and more competitive. Philippatos and Yildirim (2002) examined data on the banking sector in 14 countries in Central and Eastern Europe and found that the banking systems in countries such as Latvia, Macedonia and Lithuania were neither perfect competition nor monopoly. They also concluded that large banks were in fiercer competition than smaller ones in countries undergoing economic transformation. Some studies differentiated banks of different size and types. For instance, De Bandt and Davis (2000) found that small banks in France and Germany were in a monopolistic market environment while large banks were in monopolistic competition, demonstrating that small banks in these samples enjoy more market power as they basically exclusively owned the market share of their community. Claessens and Laeven (2003a) connected competition in the banking sector of a country with the indicator for the structural adjustment of its financial system. They used the panel data for between 1994 and 2001 to calculate the competitive value H-statistics of 50 countries. As with Bikker and Haaf (2002), they testified to varying degrees the imperfect competition of each nation. They found that some counties have numerous banks but lower level of competition (such as the U.S.). Claessens and Laeven tried to identify and distinguish factors for differences of the banking sector in different countries and used statistical data of different nations to make regression analysis of H-statistics, such as the emergence of foreign banks, limitations on business activities (engaging in the securities market, insurance and real estate market), access barriers, market structure, competition with non-bank financial institutions, overall macroeconomic conditions and the overall economic development, among others. They also found that on the surface competition and foreign banks, relaxing access restrictions and relaxing constraints over business activities have positive correlations. In any circumstances, competition has positive correlations with concentration ratio but negative correlations with number of banks. Bikker and Haaf (2002) used both the BL and PR methods to measure the competitive value of the banking industry and the results show that there was little difference. Nathan and Neave (1989) employed the PR model to research the banking sector of Canada and the research results are basically the same as those concluded by Shaffer (1993) using the BL model. Up to now, except for the BL and PR models, there are not many other testing methods for competition. Kessidis (1991) developed a contestability model that mainly focuses on sunk costs. Corvoisier and Gropp (2002) applied this model in the European banking

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market. They generally focused on the implications of information technology advancement in competition for market structure when presetting the effect of sunk costs. They found that the increasing contestability in the saving market's impact on the loan market was not obvious. They deduced that this was the result of the fact that the sunk costs dropped through technology application in the saving market are larger than that of the loan market.

Banking features influencing contestability Contestable market theory (CMT) developed by Baumol (1982) argues that if the access threshold is lower for newcomers, a concentrated industry would also face the pressures of competition. That is to say effective competition may occur in a concentrated banking market with only a few large banks. Moreover the liberalization and deregulation of the financial industry will result in fiercer and greater competition in the banking sector. Both the mixed results of studies about “concentration” and the conclusions of “contestability” literature show that competition of banks is not necessarily related to the number of banks in the market and their concentration ratio while other factors are also at play. Of these, “deregulation” is quite important. The existence of free access risks can promote banks to adjust their behavior with competition so that fewer banks exist in the market. At the same time, competitors are not only their industry peers but also other non-bank financial institutions.18 Studies show that reducing restrictions on the business activities of banks is critical to contestability, which is linked with the increase of competitive value of the whole financial system. Some scholars have made studies of bank access laws and regulation. After broad examination of the bank-related laws and regulations of 107 sample countries, Barth, Caprio and Levine (2001) tested and examined what happened around 1999 when restrictions on banks by the governments of different countries to different degrees resulted in banks’ adjustment of costs and proceedings to varying degrees, and found that stricter access requirements will exert a negative influence on the efficiency of banks and trigger higher efficiency and management costs; while preventing or limiting the access of foreign banks will make the banking industry even more vulnerable. Their empirical test demonstrates that market contestability is positively correlated with the efficiency and stability of banks. Demirguc-Kunt, Laeven and Levine (2003) studied the impact of government restriction on competition of banks on efficiency with the data of the banking level of 77 countries. They found that the concentration resulting from this will exert a negative impact on the efficiency of the banking sectors of developing countries with under-developed

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Literature Review on Banks Competition

financial systems; but developed countries feature a free market economy and enjoy a strong financial system and more economic rights so the implications of concentration generated from market conduct for efficiency are not big. A “sound” financial system should be equipped with an effective legal system, a transparent financial system and information channels, an effective capital market, a strong accounting system and regulated corporate governance. Beck, Demirguc-Kunt and Levine (2003) analyzed the relationship between concentration of the banking sector and bank crises. They used material from 69 countries between 1980 and 1997 to illustrate that crises rarely happen in countries with a sound economic system. This kind of system encourages competition and protects and supports private property rights.

Summary We can see from the above documents that it is relatively easy to measure competitive value within the framework of traditional SCP theory: a higher concentration ratio is connected with a high level of market force. However, with the drastic changes in the economic environment after 1990s, empirical studies in recent years have posed grave challenges to traditional theories. Relevant literature on contestability holds that the key to competition of the banking sector lies in the competition behavior of banks rather than the concentration ratio and the number of banks. Concentration ratio is not the indicator for measuring whether competition behavior is sufficient, as there are factors such as deregulating access, entry of foreign banks, reducing restrictions on banks’ business activities, developed and transparent financial system and institutions as well as the wide use of electronics network technologies, among others. Some other factors also play their part. Domestic and foreign literature shows that many scholars have made indepth studies of the developed countries of the Organisation for Economic Cooperation and Development (OECD) 19 in this regard, but few of them have touched on transforming countries or regions — emerging industrialized and emerging market economic countries (regions) (such as the commercial bank markets in Asia) and especially the Chinese commercial bank market. On top of that, there are even fewer studies of the developments of bank market structure and environment. This book employs the PR model to measure the competitive value of the banking industry in South Korea, Taiwan and Mainland China, discusses the development track of competition degree in these three markets over the past

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decade and explores the relationship between competition and concentration; it then adopts a non-linear stochastic frontier production function parametric model to measure the changing trend of bank efficiency of these three markets and in the end fits the relationship between competition and efficiency. Studies showcase that there is an obvious difference in relations between competition and efficiency in Asian countries and regions during different economic development stages and periods. Due to the limits of the length, this book mainly studies issues about the competition, concentration and efficiency of commercial banks. Follow-up research will be conducted on stability.

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3

Chapter

Measurement of Competition and Concentration of Banks

COMMERCIAL BANKS

Theory and Model There are two channels to describe the competition of the banking industry: the structural method and the non-structural method. The structural method mainly focuses on market structure and business scale; while the non-structural method gives priority to the environment of the competitive market.

Structural method — CR n and HHI measure of concentration Traditional industrial organization theory capitalizes principally on the SCP paradigm and believes that market structure (such as concentration level and the number of enterprises) and related conduct (such as price policy) and performance (such as return on assets [ROA], and return of equity [ROE]) have a causal relationship. The description of market structure mainly employs the concentration ratio of the largest enterprises and the HHI as indicators. It is measured through the number of businesses in the industry and its concept is based on the assumption that improving business conspiracy will weaken competition. The concentration ratio is for measuring the market share of large businesses in the industry is specifically presented as: n

∑ S (3–1) CRn = i=1 i

In the formula, Si refers to the market share of the i enterprise when it is in the descending order; n refers to the enterprise with the largest market share in the industry being measured. For example, CR 5 is the measurement of the market share of the five largest businesses. Concentration ratio indicates the degree of the market formed by a few leading large enterprises or many small ones in the industry and the market share of the banking sector is usually measured by total assets, total loans and total deposits. HHI is the quadratic sum of the market share of all businesses of a specific industrial market and can be presented as the following formula: n

n

∑ (X /X)2 = ∑ S2 (3–2) HHI = i=1 i i=1 i

In the formula, X refers to the total scale of the industrial market, Xi refers to the size of the i enterprise, Si represents the market share of the i enterprise and n refers to the number of businesses within the industry. HHI refers to the quadratic sum of the market share of each of the 50 enterprises (or all enterprises if the number is fewer than 50) in one market. Obviously, the larger the HHI is, the higher the concentration of the market

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Table 3.1. Market structure HHI value 0/1,000

Classification of market structure based on HHI value Oligopoly type Low oligopoly I

Competition type

High oligopoly I

High oligopoly II

Low oligopoly II

HHI ≥ 3,000

3,000 > HHI 1,800 > HHI 1,400 > HHI ≥ ≥ 1,800 ≥ 1,400 1,000

Competition I Competition II 1,000 > HHI ≥ 500

500 > HHI

Source: MBAlib, http://wiki.mbalib.com.

and the higher degree of monopoly will be. This index not only reflects the market share of large businesses but also the market structure outside of the large businesses. As such, it can precisely demonstrate the implications of large enterprises for the market. When an exclusive enterprise has a monopoly, this index equals 10,000; when all enterprises are the same in scale, the index is equivalent to 1/n where n tends to be infinite, and then HHI tends to be 0. In this connection, the indicator changes between 1/n–100,000, the larger the numerical value means the higher the degree of unevenness of business scale distribution (see Table 3.1). As a result of the “amplification” of the “quadratic sum”, HHI is especially sensitive to the changes of the market share of the leading few large scale enterprises. Market concentration gives rise to market force and is bound to push up prices and excess profits. Smirlock (1985), Evanoff and Fortier (1988) believe that high profits of concentrated markets will bring about production efficiency. When it specifically comes to the banking sector, the SCP paradigm signifies that the concentration of the banking industry can generate monopolistic profits through paying lower deposit interest and demanding higher loan interest. This opinion assumes that banks can overlook potential competitors due to technology and access barriers in concentrated markets. As the concept of the HHI index is not directly perceived as concentration, this book settles for concentration ratio as the indicator for the concentration measurement of banks.

Non-structural method — BL and PR model measurement of the competitive market environment The non-structural method believes that some other factors can affect competition conduct apart from market structure and concentration, such as access or exit barriers and the contestability of the market across the board

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(Baumol et al., 1982; Bresnahan, 1982; Panzar and Rosse, 1987). All these studies have developed the industrial organization theory. The last chapter mentioned that there are three kinds of non-structural method. In the financial field the latter two methods, namely the BL model and the PR model, are widely used to measure competition conduct (contestability). The Bresnahan and Lau model (BL model) The BL model was established by Bresnahan and Lau in 1982 and extended and amended by Bresnahan in 1989. This model is established on the basis of a balanced overall market. The basic viewpoint is that the marginal costs of enterprises pursuing profit maximization in balance equals their marginal income, which has determined the prices and quantity of products. If marginal income is consistent with demand, marginal costs equal marginal income, which is the same as marginal costs being equivalent to demand prices. As such conditions for competition balance occur, the BL model can differentiate the competitive value of perfect competition, monopolistic competition and monopoly through different parameter estimation. Its merit is that parameter λ can be estimated only by the general data of the industry. Of cause, data of many individual businesses can also be used to conclude results, which simplifies the BL method. According to Bresnahan (1982) and the explanations of the model by Gruben and McComb (2003), the demand function of commercial banks is: Q = D(P,Y, α) + ε (3–3) Q refers to the total output volume, P refers to price, Y represents the exogenous variable affecting demand, α is the estimated parameter while ε refers to the stochastic error term. The actual marginal income of enterprises is: MR = P + h(Q, Y, α) = P + Q/(ǝQ/ǝP) (3–4) h(Q, Y, α) is the elasticity function required by Q/(ǝQ/ǝP), and h(Q, Y, α) ≤ 0. The marginal income of businesses is: MRP = P + λh(Q, Y, α) (3–5) λ is an estimated parameter, 0≤λ≤1. λ is used to measure the difference of business demand and marginal income function. Presetting c(Q,W, ß) as the average marginal cost function of enterprises, W is the exogenous variable, and ß is the estimated parameter of the supplier. Enterprises pursuing profit

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Measurement of Competition and Concentration of Banks

maximization will preset cognitive marginal income equivalent to marginal costs, that is: c(Q, W, ß) = P + λh(Q, Y, α) P = c(Q, W, ß) – λh(Q, Y, α) + η (3–6) In the formula, η refers to the stochastic error term. If a business is the receiver of prices that in a perfect competition situation, there will be no difference between marginal income function and demand function so λ=0. If an enterprise is in a monopolistic state, the demand function and marginal function will obviously be different and the output is preset at a time when marginal costs equal marginal income, so λ=1. 0