economics of market power

7/24/2019 Economics of Market Power

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Economics of Market Power: the case of

Banking

By

Bhuvan Sethi

Uni versity of Strathclyde

Glasgow, U.K

September 2006

MSc. Economic Management and Policy.


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Abstract

Following financial de-regulation and liberalization, there has been a notable increase

in competition among banks. Contrary to popular beliefs, this increased intensity of

competition in banking markets has exposed certain structural weaknesses, which

makes the banking sector sensitive to the extent of competition in the market. In light of

such arguments, the debate on the appropriate level of competition among banks has

essentially turned into a trade-off. While textbook wisdom suggests that a competitive

banking regime maximizes efficiency and thus growth, stability, achieved through

market power, is also necessary to avoid systematic runs and failures. This paper

reviews theoretical and empirical literature on modern financial intermediation

analysis and industrial organization of banking to study this supposed trade-off.Recent studies point out to a rather interesting conclusion. That is trade-off exists is not

certain. Market power in banking can bring out the desired efficiency effects by

allowing banks to build a safe loan portfolio and thus enhance stability. Studies also

point towards the active role of regulators in promoting competitive behavior

(contestability) in the market by allowing banks to diversify and by easing entry

restrictions in order to neutralize the negative effects of market power. In turn, it is

suggested that a sound banking system should ideally resemble a market structure

which promotes competition among few or in other words bear resemblance to an

oligopolistic market structure. This paper also highlights some important policy

implications.


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Table of contents.

Chapter 1: Introduction ............................................................................................................. 6Chapter 2: Contemporary Banking Theory............................................................................. 11Introduction: ............................................................................................................................ 112.2: why do banks exist? ......................................................................................................... 142.2.1: transaction costs explanation ........................................................................................ 152.2.2: Ex-Ante Information Asymmetries .............................................................................. 162.2.3: Ex-Post Informational Asymmetries ............................................................................ 172.3: An Extra Perspective on the Theory of Financial Intermediation ................................... 202.3.2: How do Banks Create Value. ........................................................................................ 22

2.4: Do all theories of financial intermediation contradict each other? .................................. 232.5: Some final remarks .......................................................................................................... 24Chapter 3: Competition among banks-good or bad ................................................................ 263.1: The Debate Started- Competition and Banking ............................................................... 293.2: Stability vs. Efficiency Part II- Market power and Banking ........................................... 343.2.1: Market Power and Banking- The Debate Continued. ................................................... 393.2.2: Entry Barriers in Banking ............................................................................................. 403.3.3: Monopoly and Banking ................................................................................................ 433.3: Stability vs. Efficiency Part III-Oligopoly and Banking ................................................. 453.4: Stability vs. Efficiency Part IV- Debate Concluded ........................................................ 47Chapter 4: empirical evidence ................................................................................................ 494.1: Stability vs. Efficiency- empirical evidence .................................................................... 504.2: Structural Approaches to Competition and Banking ....................................................... 544.3: Non-Structural Approach to Competition and Banking .................................................. 57Section 4.3.1: The Panzar and Rosse approach. ..................................................................... 57Section 4.4: Some final thoughts ............................................................................................ 61Chapter 5: debate concluded ................................................................................................... 62References: .............................................................................................................................. 66


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Acknowledgement

I would like to thank my friends; family members and everyone at the Department of

Economics, University of Strathclyde for providing support and motivation throughout thispiece of work.

A special thanks to Mr. John Scouller for his support and guidance throughout the project.


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() we

believe that imperfect

competition is an important,

although somewhat neglected

aspect of bankingMatutes and Vives, 2000

() has the pendulum moved too far towards unleashing

competitive forces in banking?

Vives, 2001

() the time is ripe for an opendebate regarding the costs and

benefits of bank competition

Nicola Cetorelli, 2001


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Chapter 1: Introduction

A small town on the west coast of United States of Nowhere called Old York boasted of a

healthy, hard working population of about five hundred thousand. The town, like manyothers around the world, had all the modern amenities including a bank called Only Bank.

This bank was the only financial intermediary in town responsible of channeling savings to

productive investments through the supply of credit to businesses and households. Young

firms and entrepreneurs, with no past corporate history, would seek the banks help in raising

seed capital necessary to get their business started. The bank, fully aware of its position,

took its own time in screening applicants and deciding whether to extend the loan or not

depending on the respective project and the credit risk.

The citizens of Old York were seemingly unhappy with the banks behavior. The lenders

complained of getting lower than equilibrium returns on their deposits, while the borrowers

complained of restricted access, slow service and higher than equilibrium interest rates on

loans. The only entity happy about this situation was Only Bank. With lower than industry

level non performing loans assets and the ability to charge a price above marginal costs- the

bank boasted of a balance sheet, which would make any analyst on Tall Street fall in love

with it. Two questions were being asked however.

Could Only Bank be reasonably accused of socially harmful monopoly practices?

Is excessive screening and monitoring of loan applicants good or bad for the

economy?

Smelling the vast opportunities this small town had to offer, a lot of banks from all over the

country set shop in Old York. Soon this quite and peaceful town was turned into acorporate battlefield. Young bankers, armed with professional degrees, were chasing

customers offering deals too good to be true. No one was complaining, lenders got

competitive returns on their deposits, while the borrowers, even the ones rejected by Only

Bank, managed to secure credit at unbelievably low rates. The town was buzzing with

activity and market share became the new mantra for banks. Only Bank, seeing no other


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alternative, joined the band wagon. All the banks in the area were now profit maximizing

price takers supplying the greatest amount of credit at the lowest prices. New questions

began to be asked.

Is a lot of competition among banks socially desirable?

Is no or limited screening and monitoring of applicants good or bad for the

economy?

What impact would this situation have on the banks balance sheet?

As time went by, a lot of debtors, owing to failure of start-ups or insufficient profits to pay-

back, defaulted. On the consumer side, customers, who were issued credit cards without

looking into their ability to pay-back, suddenly realized they had spent more than they can

afford. The possibility of a mass default was very real. The whole banking sector in Old

York was in a mess. Realizing the grave danger this situation posed for the whole economy

of Old York, the regulator acted fast to get the situation under control. Overnight sweeping

changes were brought about in legislation encouraging mergers and acquisitions in the

banking industry. The aim was to reduce the number of banks to a few Big Ones ensuring

stability along with efficiency brought about by Oligopoly competition.

Is competition among few the optimum banking structures for an economy?

What role do regulators play in ensuring a fair and competitive banking sector?

A More Formal Introduction:

Although Old York in United States of Nowhere and Only Bank might not exist in real

world, issues regarding the nature and significance of competition in the banking sector are

gaining ground both in relevance and importance. To start with, such a debate may seem

unwarranted for. Applying welfare theorems would predict that a perfectly competitive

banking system would maximize efficiency and so be welfare enhancing. Market power, on


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the other hand, would induce a dead weight loss on the society by allowing banks to exercise

their market power and thus encourage them into charging a higher loan rate to businesses

and by giving out lower deposit rates to retail investors. Such an action would have a

dampening effect on entrepreneurial activities and also cause firms to scale down on their

R&D initiatives. Allowing higher than competitive loan rates would also bring about a

preference shift in borrowers from risk neutral projects to risky projects (since higher risk

entails higher returns), thereby weakening the overall resilience of credit markets. All this

would eventually result in an economy acquiring a slower pace of capital accumulation and

therefore diverging from the more important social goal of achieving highest per capita

income for the state.

However, research, in more recent years, has brought to light some additional issues

regarding the overall costs and benefits of bank competition on an economy. In particular, the

nature of the industry, its complex linkages with the economy and issues regarding

information economics have highlighted the need for striking a fine balance between

financial stability and competition in financial markets. In an important contribution, Keeley

(1990) revealed that though de-regulation of the financial sector in the U.S during 1970s and

80s led to reduction in monopoly rents for banks, increased competition also led to a

noticeable increase in bank failures during that period. Such an incidence was not only

restricted to the U.S but also included other countries where empirical studies have found a

significant relation between competition and financial instability. Various other studies1,

using data on as many as 70 countries, have found the relationship between competition and

financial instability to hold true. Also, the cost of such an event can be high, particularly for

emerging and less developed economies. Hoggarth and Saporta (2001)2 find the average

fiscal cost of bank crises across countries to be 16% of world G.D.P, with a higher cost of

such crises for emerging economies. Table 1 below outlines the costs of banking crises

across different countries.

1Other studies are done by Beck, Demirguc-Kunt and Levine (2003), Bikker and Haaf (2002)2Since this source is not freely available, reference is taken from Allen and Gale (2003)


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Table 1: (Source: Allen and Gale 2003)

Readers of this paper would have by now sensed the issues at stake. Over the years,

following mass liberalization and financial de-regulation, a vast amount of literature has

emerged debating on the role of excessive competition in the Banking Industry, a sign that

the time is ripe for an open debate regarding the costs and benefits of bank competition

(Cetorelli 2001). Indeed this is the subject matter of this paper Economics of Market

Power: the case of Banking.

Chapter 2outlines the Contemporary Banking Theory. The chapter would start by defining

financial intermediarys in general and banks in particular and would then go on to look at

reasons why banks exist. The second half of the chapter would examine the intricate details


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of this sector highlighting its importance to the economy and issues such as moral hazard,

adverse selection and the need for screening and monitoring.

Chapter 3 would build on the previous chapter and focus on issues relating to market

competition in the banking sector. In particular, the chapter would argue why a certain degree

of market power might be beneficial for the banking sector and how it (market power) can

create both stability and efficiency.

Chapter 4 reviews the empirical evidence provided on this subject, looking at both, the

structural and non-structural approaches to competition in banking.

Chapter 5concludes the debate.


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Chapter 2:Contemporary Banking Theory

Int roduct ion:

Moving away from our imaginary world of Only bank into the real world; this chapter talks

about banking theory in a contemporary framework. Traditionally (up until the late 1960s)

economic theory and analysis failed to recognize the importance of financial intermediation3.

The design of the financial sector was thought to be of no major importance for economic

decision making and was thought to produce nothing but a veil over the true determinants of

economic development (Theil 2001).

Generally speaking, the early literature on microeconomics (like Patinkin, 1956) failed to

recognize the importance of financial intermediaries as it came to light under the auspices of

perfect markets and complete information. In fact under the traditional Arrow- Debreu model

of resource allocation, banks seemed to be no more than redundant institutions. This came

about as in the Arrow-Debreu world, savers and investors costlessly found each other since

they had perfect information on each others choices and so did not need intermediation

services to exchange savings in return for financial products. Also, the Arrow-Debreu world

assumed no transactions or search costs to be involved in such an exercise and hence found

the needs of both investors and borrowers to be met fully and simultaneously. With the

result, present value prices of investment projects became well defined and so banks as a

decision making agency had no impact on other agents.

However, with the emergence of a new paradigm: the asymmetric information paradigm,

economic theory onbanking has entered a process of change that has overturned economists

traditional vision of the banking sector. Revolving around the assumption that different

agents possess unique bits of information on various economic variables and that the agents

use this information for self profit maximization, asymmetric information paradigm has

helped explain the role of banks in the economy and highlighted the structural problems in

3Financial intermediary and banks would be used interchangeably in this chapter.


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the banking sector (like financial contagion and susceptibility to runs and panic) that may

justify public intervention.

The current chapter, thus building on the new paradigms, addresses issues regarding what

banks are? What do they do? And why do they exist? This, in my view, is an important first

step towards analyzing the bigger issue, that of the appropriate level of competition in the

banking industry. From the view point of the society, every competition model (textbook

models on perfect competition, monopoly and oligopoly) has some positive as well as

negative aspects around it and to be able to judge or comment on the optimal market

structure for any industry, a necessary precondition is to be aware of the industry

characteristics. This is what the aim of this chapter is.

Section 2.1 starts off by defining a bank and then goes on to consider what they do. Section

2.2 discusses the traditional theories of financial intermediation. Section 2.3 considers a new

line of research on banks. Section 2.4 comments on the different theories of financial

intermediation. Section 2.5 leaves some final remarks, emphasizing the significance of all

this for our view of competition in banking sector.

2.1: What is a Bank and What do Banks do?

In crude terms, banks can be defined as entities that channel funds from savers to borrowers

and transfer returns from borrowers back to savers. However a more formal definition, one

used by the regulators, is also available: a bank is an institution whose curr ent operati ons

consist in granti ng loans and receiving deposits from the public(Freixas and Rochet,

1997). This formal definition has two important aspects to it. Firstly, the word current is

important because most industrial or commercial firms occasionally lend money to their

customers or borrow from their suppliers. Secondly, the fact that both loans and deposits are

offered is important because it is the combination of lending and borrowing that is typical of

commercial banks.


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Historically, the existence of banks is justified by the role they play in facilitating inter-

temporal allocation of household consumption and by allocating physical capital to its most

productive use in the business sector. If someone would have asked twenty years ago: how

financial intermediation improves resource allocation? The answer would have been by

lowering transaction costs; however with advances in both banking theory and information

economics, today transaction costs would be identified with only a fraction of what banks are

supposed to do. Apart from the well established functions banks perform like Liquidity and

Payment Services, Money Changing, Payment services, Managing Risk, Managing Interest

Rate and Liquidity Risk, Off-Balance-Sheet Operations and Resource Allocation, banks also

play a role in Asset Transformation and Monitoring and Information Processing. Figure 2

lays down the functions of a Financial Intermediary.

Figure 1 (Source: Bhattacharya and Thakor, 1993)


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2.2: why d o b anks exist?

Recall from the previous section, where we defined a bank as an institution whose currentoperations consist in granting loans and receiving deposits from the public. Now, an alternate

version of this definition in terms of defining a Financial Intermediary (FI) in general can be

that of an economic agent who specializes in the activities of buying (buy the securities

issued by borrowers i.e. grant loans) and selling(selling the same securities to lenders i.e.

collect deposits) (Frexias and Rochet, 1997). Both the definitions stated above are quite

similar in nature to the notion of intermediaries in the theory of Industrial Organization. The

justification given by the theory of Industrial Organization to the existence of such

intermediaries is simply the presence of frictions in transaction technologies (For example,

Brokers and Dealers operating in financial markets).

However, banking activities are in general more complex, for at least two reasons:

Banks usually deal (at least partially) with financial contracts (loans and deposits),

which cannot be easily resold, as opposed to financial securities (stocks and bonds),

which enjoy a flourishing secondary market. Therefore banks typically, must hold

these contracts in their balance sheets until the contract expires.

The characteristics of the contracts or securities issued by firms (short-term or long-

term loans) are usually different from those of the contracts or securities desired by

investors (time deposits etc.).

Thus as figure 2 above and research by the likes of Gurley and Shaw (1960) and more

recently by Fama (1980) suggests, banks are there to transform financial contracts and

securities to suit the needs of the investor class both on the demand side and the supply side.

Of course, in the Arrow- Debreu world, as discussed above, one would not feel the need for

such an intermediary since both investors and borrowers would be able to diversify perfectly

and obtain optimal risk sharing. But as soon as one takes into account even the smallest of

deviations from this ideal world and considers the so called frictions in the transaction


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technologies, financial intermediaries in general and banks in particular are needed. The

following sub sections dwell on such explanations for the existence of banks in an economy.

2.2.1: Transact ion co sts explanat ion

Transaction costs explanation is one of the standing pillars on which the early literature on

banking was established4. According to the views held at that time, banks were considered to

be mere asset transformers, transforming deposits of convenient maturity, such as demand

deposits into non marketed loans with a longer maturity and in large amounts with more risk.

And in performing the role of an intermediary as an independent unit, banks were able to

attain economies of scale and scope5.

However, microeconomics of banking, per se, cannot be established totally on such grounds.

Even if historically physical and technological costs have played an important role in the

emergence of FIs, it should be kept in mind that th ese costs are given exogenously. With the

progress experienced recently in telecommunication and computers, as well as related

advances in financial instruments have all undermined the basis of such arguments. Though

at a nascent stage, firms, governments and people alike have realized huge efficiency gains

from E-business and the concept is surely to grow. By producing real-time information and

by providing a common ground to both producers and consumers, e-business has slowly

started to change the way firms do business and has threatened the very existence of

intermediaries in traditional industries. A successful example of such new practices can be

internet portals such as E-bay and Amazon etc. which have provided a common ground to

both suppliers and consumers, eliminating the need for an intermediary.

The point here is that unless a more fundamental form of transaction costs is not present,FIs are bound to disappear. (Freixas&Rochet, 1997). As I had mentioned in the start of this

chapter, asymmetric information has played an important role in helping to build a theory on

4For detailed study, readers can refer to Benston, G and C.W. Smith.(1976)5For example, fixed costs of asset evaluation mean that intermediaries have an advantage over individualsbecause they allow such costs to be shared. A more detailed study on such scale economies can also be found inFreixas and Rochet, 1997 pg 18-20


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banking and shown ways to overcome the market imperfections generated by such

asymmetries. It would thus only be logical to find answers to our questions based on such

concepts. The two topics explored in the following sub sections are Adverse Selection (ex-

ante) and Costly State Verification (ex-post).

2.2.2: Ex-Ante Informat ion As ymmetr ies

First conceived by an American economist, George Akerlof in the 1970s, adverse selection

refers to a situation wherein the marketplace would generally contain poor quality products if

buyers are not able to accurately judge the product quality. Akerlof (1970) demonstrated that

in the presence of asymmetric information, equilibrium no longer requires supply to equal

demand and can cause markets to vanish completely.

To seek justification for the existence of banks while considering the adverse selection

paradigm, consider a situation where no bank exists. Now, a large number of entrepreneurs

are there in an economy who, although can afford to fund their projects, would like to borrow

money from investors. Investors on the other hand have limited information on the viability

of the project in a sense that some information about the project is privately held by

borrowers and that entrepreneurs are indistinguishable by investors. In a situation like this,

what options do the investors have in order to gauge the success of the project in question?

In a seminal contribution, Leland and Pyle (1977) demonstrate that borrowers can signal

about the viability of their project through Self Financing.This conclusion seems logical.

After all if a borrower is willing to part finance the project then in a sense he is sending a

positive message to the investor class about the prospects of his venture and by observing the

stake an entrepreneur is willing to hold in his proposed project, the investors can separate the

good projects from the bad projects. By following such procedures, the problem of

adverse selection can be partially overcome.


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However, assuming that the entrepreneur is risk averse, this signaling process can be costly

since the borrower has to invest his own money in order to get funding. Leland and Pyle6

show that if borrowers form a coalition, which they interpret as F.Is, then although the

expected returns per project remain the same, the unit cost of capital decreases with the size

of the coalition borrowers. Thus by looking at banks or FIs in general as information sharing

coalitions, the adverse selection paradigm can generate economies of scale in the borrowing-

lending relationship.

2.2.3: Ex-Post Inform at ional As ymmetr ies

Ex-post informational asymmetries (monitoring) generates another imperfection which

justifies the existence of banks. In the previous section, through a theoretical model, we saw

how banks can be interpreted as information sharing coalitions which generate economies of

scale in the borrowing-lending relationship. Now suppose that the entrepreneurs have secured

the loan from investors and as before some information about the project, be it cash flows or

technology, is privately held with the entrepreneur. In such a case monitoring the project

would not only be efficient but also necessary in order to prevent opportunistic behavior of

the borrower during the realization of the project (moral hazard). In fact, Schumpeter (1939)

has essentially assigned such a role to banks.

() the banker must not only know what the transaction is which he is asked to finance and

how it is likely to turn out but he must also know the customer, his business and even his

private habits, and get, by frequently talking things over with him, a clear picture of the

situation

Schumpeter (1939), pg.116, Source: Diamond (1984)

So, to see how banks can be efficient in performing their role as delegated monitors, I

consider alternate methods through which investors can monitor the performance of their

concerned projects.

6For a mathematical derivation and detailed discussion refer Leland and Pyle (1977).


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Propositi on 1:the investors monitor the projects themselves.

In such a case each investor or a small group of investors who have financial interest in their

respective projects are entrusted with the task of overseeing the performance of the project

(Figure 2 below). Clearly for such an arrangement to be feasible there have to be few

investors, each with significant capacity. However, even in a case like this where

F igure 2(Source:Freixas and Rochet, 1997)

there are few investors, a free riding problem exists. Note that the investors would have to

incur some costs on their part in order to monitor the project. Now, if one of the investor acts

opportunistically and observes others rather than incurring expenditure on monitoring, he

would be able to extract costly information for free. With the result, no investor would be

willing to take on the monitoring responsibility.

Borrower 1

Borrower 2

Lender 1

Lender 2

Lender 3

Lender n


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Propositi on 2: banks act as delegated monitors.

Now instead of investors indulging in self monitoring, lets assume they delegate the

monitoring activity to banks. Figure 3 below shows such an arrangement. As soon as banks

come into the picture, things look a lot simpler. The investors delegate the monitoring

function to the bank which oversees the borrowers and in return offers a debt contract or

more accurately a deposit contract to each investor which promises a nominal amount in

exchange for the deposit. And of course, this is not only more efficient but also more secure

since the banks can be liquidated (ignoring the fractional reserve requirement for the time

being) if it is unable to pay its depositors.

F igure 3 (Source: F reixas and Rochet, 1997)

Borrower 1

Borrower 2

Bank

Lender 1

Lender 2

Lender 3

Lender n


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However, for banks to act as delegated monitors certain conditions must be met. These are:

Scale economies in monitoring should exist. This implies that a typical bank should

finance many projects.

Small capacity of investors as compared to the size of investment projects. This

implies that each project needs the funds of several investors.

Low cost of delegation: the cost of monitoring or controlling the FI itself has to be

less than the surplus gained from exploiting scale economies in monitoring or

controlling investment projects.

Certainly, all the pre conditions listed above for banks to act as delegated monitors seem

realistic. Real world banks are one of the primary sources for commercial finance in an

economy and the fact that they help in channeling consumer savings (which tend to be low)

to productive means is well researched and documented. This, in essence, was the

contribution of Diamond (Diamond 1984) who forwarded the theory of financial

intermediaries as delegated monitors.

2.3: An Extra Perspect ive on the Theory o f Financial Intermediat ion

Apart from the well established asymmetric information paradigm based theory of banking,

another new line of research has emerged which analyses the theory of banking (and

financial intermediation) through the lens of risk management rather than the traditional

approaches7. Though not much research has been done in this field, the idea itself sounds

interesting and worth considering in this paper. As I have said before, the motive of this

chapter is to reconcile the different theories of financial intermediation in order to build a

solid foundation for our main research question and as such, like with others, only a brief

outline would be included.

In a paper by Bert Scholtens and Dick van Wensveen (2003) the authors have argued about

the validity of informational asymmetries explanation of banks in wake of rapid

7The traditional approach refers to the informational asymmetries and transaction costs.


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diversification and technological progress in banking. At the heart of their argument lies the

Value Creation concept originally forwarded by Porter. Acknowledging the pivotal role

played by traditional theories in helping to build a sound theory on banking, the authors have

taken a different stand on why banks in particular and financial intermediaries in general

exist.

According to Scholtens and Wensveen (SW hereafter) the primary function of a bank is not

to intermediate between savers and investors by producing information on borrowers and

passing it on to savers or to behave as a delegated monitor on behalf of its depositors but to

deal with money and risk. As such, according to SW, even the primary role of channeling

savings into productive use has a hidden perspective to it. While considering different

projects for investment purposes, banks have to undertake large research, legal, and

organizational costs which might prove to be prohibitive for any one single investor. Banks

on the other hand can perform these functions for a group of investors and lower the unit cost

per investor. Also, by evaluating various investment avenues, banks are able to diversify

risks and achieve economies of scale.

Apart from the traditional role of improving resource allocation, banks also encourage

individuals to save more resourcefully by offering products which combine the

characteristics of insurance, depositing and investing. In other words, financial products most

relevant to entrepreneurs like bonds and equities may not be relevant in terms of liquidity,

risk and maturity to savers (like savings and pensions account). Thus, by offering such

maturity matching services banks, in a way, determine the amount of savings in an economy.

By performing this task of asset transformation, SW suggests that banks create value.

According to them information production is essentially a means to the end of such value

creation and risk management(SW 2003).


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2.3.2: How do Banks Create Value.

So if, banks are to be interpreted as value creators instead of information producer, then the

obvious question is: how do banks create value? The authors note that while banks offer

financial services personified in form of financial instruments, neither the savers nor the

borrowers create value themselves and in many cases, cannot be created by banks

individually. The value creation process is initiated and enhanced by competition between

existing players and new entrants. Considering the fact that the main functions of a bank, as

identified by the contemporary banking theory (see section 2.1), aims at addressing the needs

and preferences of savers and investors through a continuum of financial services; it is only

logical to state that they (banks) have to come up with new solutions to accommodate

changing needs of both the savers and investors. In fact through out the history of the

banking industry, all kinds of payment and credit facilities have been introduced by the

financial services industry and not by individuals themselves.

Coming back to competition and the need for innovation, as soon as an instrument developed

by one bank or an insurance firm gets commoditized and made tradable on open market,

other banks try and develop new, specialized instruments for new specific markets. This in a

way confirms to the Schumpeterian view of creative destruction in that firms have to

constantly innovate to stay ahead in the market.

Of course, there would come a time when traditional markets would saturate but therein lies

the reason for innovation. Financial intermediaries, in order to survive, would continue to

develop and penetrate into niche submarkets. The point here is that when looked at from the

lens of risk management, banks seem to function as value creators by transforming risk and

not as information producers.


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2.4: Do al l theor ies o f f inancial intermediat ion contradic t each

other?

The current chapter has covered three theories of financial intermediation in brief. While

section 2.2 talked about the transaction costs and information asymmetries explanation

for banks, section 2.3 presented a new line of thought which sees banks as value creators. Do

the three theories contradict each other? And if yes, which one of them is of relevance to us?

In my view, all the three theories of financial intermediation play a significant role in

explaining why banks exist and the conflicting nature, which might emerge, can be attributed

to the fact that theories of financial intermediation have all been developed from an

institutional perspective i.e. where the central focus is on the activities of existing

institutions such as banks and insurance firms rather than from a functional perspective i.e.

based on the services provided by the financial system. So, whilst the transaction costs

explanation would have been suffice in explaining why banks exist during the Italian

renaissance era, when they were primarily seen as money changers and a source of liquidity

and payment services, the 70s researchers saw them as information producers. And today,the world sees them as value creators.

In an important paper, Merton (1993, see also Merton and Bodie 1995) has argued that while

the functional perspective of a bank (asset transformation and risk management) has

remained stable over the years, there has been a change in the institutional perspective of

banks due to the changing face of the financial services industry itself. With the advent of

information and communication technologies and both broadening and deepening of

financial markets (as a result of deregulation) has led banks and other financial institutions to

pursue diversification strategies in order to survive (Section2.3.2). As a result, whilst some of

the activities banks indulge in can be explained using traditional theories, others cannot be.

For example, while the standard argument for existence of mutual funds lies in diversifying

asset holdings as to get better returns; high trading costs prohibit individuals to do so alone.


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Mutual funds, on the contrary, can allow individuals to diversify better by pooling their

investments and trading on behalf of them and thus achieving the desired results more

cheaply and more efficiently. Given this explanation, one might be forced to think that if

individual trading costs were lowered considerably, individual interest in mutual funds would

fall. However this behavior has not been observed in real world.

Allen and Santomero (1997) study the share of mutual fund ownership on the New York

Stock Exchange (NYSE) during the 1970s and found that though competition for brokerage

fee and the availability of real time information through channels like Reuters etc. had

considerably reduced transactions cost and informational problems for individual investors,

the share of mutual fund ownership during that period actually rose. In fact intermediation

services have grown in both relevance and size in the face of declining frictions since.

The point here is that while institutions have come and gone, evolved and changed, but the

functional needs persist while packaged differently and delivered in substantially different

ways (Allen and Santomero 1997). So if one looks at why banks exist from a functional

viewpoint, all the theories on banking complement each other. While the transaction cost

explanation can be seen as rationalizing the role of intermediaries in the distribution function

(liquidity and payment services), the information asymmetries explanation can be seen as

both the origination and servicing function (adverse selection, moral hazard and monitoring),

the value creation explanation can be seen as a risk management function where

intermediaries allow risk to be allocated efficiently at minimum cost.

2.5: Some final remarks

The current chapter discusses the theory of financial intermediation while outlining theimportant function banks play in an economy. In particular, banks are entrusted with the

responsibility of channeling savings to productive investments and also play an active role in

asset transformation, information processing and risk management. A well functioning

banking system contributes positively to economic growth and in fact has been well

documented for some time in empirical literature on economic growth.


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Additionally, given the nature of this industry, its complex linkages with the economy and

issues regarding asymmetry information and risk transformation have all made this industry

vulnerable to potential runs and systematic failure. Also, considering the high degree of inter

dependence between banks through the inter bank money markets, payments systems and

derivatives has meant that the banking system as a whole is even more vulnerable to financial

risks. So if, one day Only Bank fails owing to a credit or liquidity shock, then it would not

only affect its customer namely borrowers and lenders but also other banks which are linked

through the inter bank money market system and other arrangements.

All of the features discussed above and many more have made banking a special industry in a

sense that stability is considered vital for a well functioning financial system and as such

thrown open many important questions like what does competition mean for the banking

market? How best can financial stability be maintained while still ensuring a competitive

behavior? And is competition among banks at odds with the equally important goal of

financial stability? These are some of the issues which would be explored in the next

chapters.


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Chapter 3: Competition among banks-good or bad

Int roduct ion:

The current chapter starts from where we left the previous chapter that is to seek answers

pertaining to the appropriate level of competition among banks. To start with, such a debate

may seem unwarranted for. Applying textbook welfare theorems would predict that a

perfectly competitive banking system would maximize efficiency and be welfare enhancing.

Market power, on the other hand, would induce a dead weight loss on the society by allowing

banks to exercise market power and thus charging a higher loan rate to businesses and by

giving out lower deposit rates to retail investors. Such an action would have a dampening

effect on entrepreneurial activities and also cause firms to scale down on their R&D

initiatives. Allowing higher than competitive loan rates would also bring about a preference

shift in borrowers from risk neutral projects to risky projects (since higher risk entails higher

returns), thereby weakening the overall resilience of credit markets. All this would eventually

result in an economy acquiring a slower pace of capital accumulation and therefore diverging

from the more important social goal of achieving highest per capita income for the state.

However, in more recent years, researchers, by studying additional issues regarding bank

competition, have highlighted potential negative aspects of excessive8 competition in the

banking industry. The view supporting market power in banking has mainly originated due to

certain traits the sector commands. In particular:

Banks are more vulnerable to panic runs and risk of failure since their ba lance sheet

consists of short term deposits on the liability side and long term assets on the assetside that are difficult to liquidate quickly. In the absence of deposit insurance and

maturity matching products, this puts banks at significant risk.

8Here the term excessive competition should be interpreted in literal sense. Recent literature on competition inbanking uses this term frequently and simply presents the current state of the banking industry in certainmarkets. For e.g. refer, Vives (2001)


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Highly leveraged firms have a tendency to undertake more risky activities since its

shareholders are widely dispersed and so its activities difficult to monitor. Banks tend

to fall in this category. Large shares of debt holders in banks are depositors who have

small claims and as such lack the necessary skills and time to monitor the banks

activities and consequently the potential risks.

These and other characteristics (section 2.1) of banks have made them special in a sense that

stability, achieved through market power, is conceived necessary for a flourishing banking

system since banks with higher profits would be, in principle, better placed to absorb any

shock to the liquidity system.

Also, as established in the second chapter, banks primarily exist due to indivisibilities in the

financial system and are seen as information producers and risk transformers. As such, this

makes banks prone to market failure. In particular, I discuss market failure arising due to

asymmetric information.

Asymmetric information and market failure: banks are prone to informational

asymmetries on both the liabilities side and the asset side. On the liability side, asymmetric

information arises since depositors do not possess the requisite information on the true valueof their respective banks loan portfolio or in other words the viability of loan hand outs due

to the obvious reasons of lack of time and experience in gauging the default probability of

loans. In addition, banks are required to maintain a fractional reserve system (minimum

liquid asset holdings) to act as a buffer against mass withdrawal. However, if this fractional

reserve holding is only partially backed by reserves, then a mass withdrawal, triggered by

release of bad information about the banks assets can lead to illiquidity and even default9.

Such a process is helped by the fact that a depositors outlook on safety of his deposits

depends on their place in line at the time of withdrawals or the so called first come first

serve principle. So if depositors panicabout the safety of their deposits, they may try and

9Such a constraint is not only observed in the banking system, but is common throughout the financial system.As such, stock markets quite often experience such so called announcement effect where selling by fewplayers on the market triggers the stop loss and the index plunges.


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Figure 4:Inter-bank linkages

Source: Northcott (2004)

withdraw funds before anyone else does and in due course causing a panic run on an

otherwise sound bank and thus forcing bankruptcy.

On the asset side, as discussed in the second chapter, there exists information asymmetries

between the banks and its loan applicants. In particular, banks are not fully informed about

the risk-return characteristic of the project which may give rise to adverse selection, moral

hazard and ex-post verification problems (refer section 2.2.2). All three problems hinder

borrowers to raise the necessary capital from lenders, even where the projects project a

positive net present value. (Canoy et.al. 2001).

Finally, another peculiar characteristic of banks being the high degree of co-operation among

them has made the industry even more prone to systematic risks and failure. In fact, banks in

an economy are inter- connected so strongly through various arrangements that one refers to

them as a banking system and not just as n number of banks functioning independently.

With the result, that even if a single bank fails in an economy

(due to a credit or a liquidity shock), it can infect the whole

banking system. Although research on the effects of

contagion on financial stability is scarce, Allen and Gale

(2000b) provide some important results. The authors

consider a regional banking system connected through a

network of inter-bank deposit services and how a liquidity

shock to one regional bank can infect the whole banking

system through this network. Since no banking market is

connected to the same degree, nor is the level of regional

economic integration anywhere in the world, the authors

consider three types of inter-bank money market system as

shown in figure 4. Of the three types discussed, a complete

market is thought of as one where each bank has links to every other bank in the region. An

incomplete structure is one where banks have links with their adjacent banks only. The

incomplete and disconnected structure is where regional banks do not have any relation on


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the inter-bank money market. In such a setup, the authors demonstrate that while a complete

structure is most insulated to a contagion event due to a large number of banks sharing the

shock and so possibly lowering the cost of the event, incomplete market structure is most

susceptible to contagion since the cost is borne by a few banks. The problem is aggravated by

the fact that since fewer number of banks borne the shock, the likelihood of any one bank

absorbing the shock is low and so the spillover effect continues to act and spread contagion

across the region. Within the incomplete market structure, an incomplete and highly

connected one poses as the most susceptible to contagion.

In light of such arguments, the debate on the appropriate level of competition has essentially

turned into a trade off. While the traditional Industrial Organization (IO) theory deems

perfect competition ideal for banking, as it maximizes allocative efficiency (ensuring the

greatest amount of credit at lowest prices), research in recent years and the discussion above

have highlighted how a fragile banking system can be exposed to financial instability.

Indeed, as discussed in the first chapter, financial de-regulation in the U.S during the 1970s

was thought to be one of the major factors behind the banking failure during the 1980s. Such

incidents were not only restricted to the U.S but have started to emerge all over the world. In

a study by Hoggarth and Sapporta (2001, refer chapter.1), the authors found the costs of

banking crises alone throughout the world to be 4.5% of world G.D.P.

Then to model such a trade off is not trivial and requires us to work out which kind of a

market structure, if any, would promote both stability and economic efficiency (allocative

and productive efficiency). The following sub-sections would essentially contribute to such

a debate, while analyzing the different competition structures in the context of banking.

3.1: The Debate Started- Competition and Banking

From the point of view of social welfare, economists favor competition since under it firms

are encouraged to utilize scarce resources in an efficient manner leading to a higher

consumer surplus than under firms operating with market power.


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On the extreme lies Perfect competition wherein forces of demand and supply work freely to

determine the allocation of resources among different goods and distribution of income

among other factors. In this market structure, the degree of competition is so high that no

individual firm can influence the price of the product. The perfectness comes about in the

market under certain conditions such as:

Economies of Scale are small relative to the size of the market. This means that

average costs will rise rapidly if a firm increases output beyond a relatively small

amount.

Output is homogeneous. That is, consumers cannot distinguish between products

produced by different firms.

Information is perfect. All firms are fully informed about their production

possibilities and consumers are fully aware of their alternatives.

There are no entry or exist barriers. This means that the number of firms in the

industry adjusts over time so that all firms earn zero economic profits or competitive

rate of return.

In the context of banking, such a market structure would imply that there are a large

number of small profit maximizing banks in a market, each offering a set ofhomogeneous deposit and lending contract at market determined prices. Such an

arrangement would lead to greatest amount of credit being offered at lowest prices and

would thus maximize welfare.

However, due to market imperfections such as imperfect information, entry and exit

barriers and product differentiation, a perfectly competitive world mainly resides in

textbooks. As such, no industry conforms to these assumptions and certainly not banking.

Remember that, our discussion on why financial intermediaries exist at the first place was

derived from existence of large economies of scale and scope and asymmetric


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information. Also to the extent that there are considerable amounts of sunk costs10in this

sector, the assumption that no entry barriers exist is also misplaced.

However, to keep the debate alive on the appropriate level of competition in the banking

sector, we can certainly analyze the effects of excessive competition in this sector.

Besanko and Thakor (1992) examine the market for loans and deposits in a theoretical

context where banks differentiate themselves from competitors11 spatially. The model

itself works under the assumption of free flowing entry in that the market for loans and

deposits is fiercely competitive. The model also assumes that banks have very little

market power (arising out of locational advantage), with the result that no single bank can

influence market prices12.

In such a setup, the authors conclude that loan rates decrease and deposit rates increase as

more banks enter the market. The result sound encouraging. Lower lending rates and

higher deposit rates would stimulate higher entrepreneurial activity in the economy and

would encourage firms to invest more in their R&D operations. This would not only

accelerate the pace of technological innovation and productivity growth, but would also

result in a faster process of capital accumulation and therefore highest levels of income

per capita.

However, as with every model, the outcome achieved here is been made possible due to

certain assumptions which when relaxed may not present the ideal situation. In particular,

the authors assume that borrowers would eventually obtain credit from some bank.

Realism warrants us to assume that generally a market place would consist of two types

of borrowers: Good borrowers, who repay on average and Bad borrowers who are

not able or do not intend to pay their loans. Also assuming that banks would like to fund

only good borrowers, Shaffer (1998) demonstrates that in a market with large number

10For example, traditional banking is very much based on physical presence so that branch network has to beestablished. Even for internet banking, banks have to invest a lot in reputation.11The banks differentiate themselves spatially. This approach is similar to Salop (1979) and Hotelling (1929)12An increase in the number n of banks in this model reduces the extent of bank differentiation.


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of banks, the chances that any given borrower would not get a loan (including the bad

ones) is very low.

The intuitive idea behind such a result is that the least risky or good borrower will tend

to be approved by the first bank approached. If credit screening is imperfectly correlated

across banks and if each lender is unaware of whether an applicant has been rejected by

other banks, riskier applicants would shop around until some bank is willing to extend

a loan. In such a world, Shaffer shows that the average creditworthiness of the pool of

applicants is then systematically degraded as a function of the number of banks. With the

result, the expected loan losses also become an increasing function of the number of

banks. Of course, one can argue that access to credit bureaus and other tools of

information aggregation can mitigate such adverse selection effects by making banks

aware of a borrowers prior application to other banks. To this, Nakamura and Shaffer

(1993) suggest that even when a banks awareness of prior applications is coupled with

the additional knowledge of prior rejections, the resulting aggregation of information may

not always suffice to offset the adverse selection completely.

Besides assuming that the borrowers eventually manages to secure a loan contract from

some bank, Besanko and Thakor also assume that when a borrowers project is

unsuccessful, the banks collect nothing. To the extent that expected loan losses become

an increasing function of the number of banks, no collateral requirements or no

punishment for non payment of loans can increasingly attract bad borrowers, thus

affecting a banks net worth (banks equity).

A shock to a banks net worth can affect the amount of credit it supplies since the

quantity of credit available not only depends on market structure but also on factors such

as net worth. Banks finance lending with liabilities (such as deposits) and equity and as

such are subject to capital requirements that set a minimum allowable capital-to-asset

ratio, which takes into account the riskiness of assets. Therefore extending loans to risky


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customers can lead to lowering of a banks net worth which can lead to a decrease in

lending and consequently lower economic growth13.

According to Northcott (2004), if a banks capital-to-asset ratio falls below a set

minimum level, it is left with two options. Firstly, the bank can restore its capital by

either issuing new capital or by decreasing dividend pay outs. While the former would

prove costly, the latter would adversely affect its share prices and thus its net worth. The

second choice is to decrease its assets; that is, to decrease lending.

Therefore, by lending to bad borrowers and then having no solution to recover would

provide a negative shock to the banks net worth resulting in lower lending even in a

competitive market structure.

Another feature of the Besanko and Thakor model is that the market for loans and

deposits is fiercely competitive. Intuitively, this means that no single bank is big enough

and thus has low earnings. Given the fact that an excessively competitive market

structure in banking can result in a poor loan portfolio build up and negatively affect a

banks net worth, what implication does such a situation have on financial stability? As

weve discussed above, banks are connected through a series of arrangements, enabling

them to carry out payment and other services efficiently and how this interconnectedness

can result in a systematic failure. Again, given that in the Besanko and Thakor world the

banks are small and bad assets would form a significant part for the aggregate industry, a

liquidity shock to one bank would spread faster to all the other banks simply because no

one bank has the capacity to absorb the shock, thus degrading the overall resilience of the

financial system. In fact such market structure confirms to the incomplete and highly

connected market structure proposed by Allen and Gale (2000b) which is highly prone

to contagion.

13Literature of finance-growth nexus describes such a lending channel where lowering of a banks net worthaffects its credit supply. E.g. Bernanke, Gertler and Gilchirst, 1996


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The discussion so far suggests that the efficiency stability trade off is not as straight

forward as the traditional IO theory suggests. Although near perfect competition

conditions would reduce lending rates and increase deposit rates in the short run, the

inherent market imperfection in this sector would introduce instability in the long run and

defeat the whole purpose of competition itself.

In light of such arguments, would it be safe then to abandon competition in favor of

stability. Put differently, would a monopoly banking system be able to deliver stability

and at the same time ensure allocative efficiency. Alternatively can an oligopolistic

banking system ensure such goals? Another important aspect not discussed till now is

the role of regulation in banking. The banking industry is among one of the most highly

regulated industry world over and as such warrants a discussion on how useful it is in

contributing to the efficiency- stability tradeoff. The next sub-section discusses these

issues.

3.2: Stability vs. Efficiency Part II- Market power and Banking

Market power can be defined as the ability of a firm to price above marginal cost without

losing all its customers to competitors. At the extreme lies monopoly, wherein there

exists a single seller and as such does not face any competitor from any close substitute.

Since a monopolist faces a downward sloping demand curve, the inefficiency in

monopoly pricing stems from the fact that a monopolist restricts output in order to earn

monopoly revenues. And by doing so, a monopolist inflicts a dead weight loss on the

society.

A second effect of monopoly power is the transfer of surplus from consumers to the firmas profits. Under competitive pricing, both monopoly profits and the dead weight loss

would have gone to consumers as surplus. In order to realize a larger share of the gains in

trade, the monopolist raises price above marginal cost. However, this comes at a cost to

society in the form of lost surplus, since some consumers respond to the price rise by

reducing their quantity demanded.


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Applying the same arguments to the banking industry, one can argue that banks with

market power would also restrict output (increase lending rates) and decrease deposit

rates in order to earn monopoly revenues. However this does not happen in practice.

Stiglitz and Weiss (1981), through a theoretical model, demonstrate that banks essentially

ration creditinstead of increasing lending rates in concentrated markets14in response to

excessive demand for loanable funds.

The rationale behind why banks behave in this way is in part due to the winners curse

argument forwarded by Shaffer (1998). In particular, banks making loans are only

concerned about the interest rate they receive on the loan and the riskiness of the loan.

However, the interest rate a bank charges may itself affect the riskiness of the pool of

loans. This cause and effect relationship is again derived from the imperfect information

(adverse selection and the incentive effect) which is present in the loan market.

Remember from our discussion on adverse selection above that a market place would

generally consist of two types of borrowers: good borrowers, who repay their loan and

bad borrowers, who do not repay their loans. Also, since the expected return to a bank

depends on the probability of repayment, a bank would obviously be interested in

gauging the repayment capacity of the borrowers so that it only funds the good

borrowers. As such, identifying a good borrower ex-ante from a pool of borrowers is a

difficult task and requires the banks to implement a variety of screening devices. In their

model, Stiglitz and Weiss assume interest rates, which individuals pay, to act as such a

screening device: those who are willing to pay high interest rates may on average, be

worse risks; they are willing to borrow at high interest rates because they perceive their

probability of repaying the loan to be low. As the interest rate rises, the average riskiness

of those who borrow increases, possibly lowering a banks profit.

14Although Stiglitz and Weiss do not explicitly model competition among banks, they work on the assumptionthat banks are price setters on the credit market and quantity setters on the deposit market.


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Another peculiar problem which the authors point out a bank faces while deciding on the

interest rate is the change in the borrowers behavior towards risk taking in relation to

interest rate changes. To the extent that information is perfect and costless, banks, in

order to maximize returns, would simply stipulate precisely all the actions a borrower can

undertake. However due to asymmetric information, banks are not able to directly control

all the actions of the borrower. To circumvent this problem, banks would formulate the

terms of the loan contract in a manner designed to induce the borrower to take actions

which are in the interest of the bank, as well as to attract low risk borrowers.

A common thread running through both the arguments above is that higher interest rates

imply higher risk taking behavior. The fundamental premise behind such thought is that

in presence of other sources of finance such as secondary markets, an interest rate hike

(beyond a certain point) in response to excessive demand for loanable funds would not

only drive away good borrowers15and at the same time induce risky borrowers to come

forward but would also encourage risk averse borrowers to shift to risky projects16.

With the result, the market for loanable funds faces a backward bending supply curve in

that the expected return by the bank may increase less rapidly than the interest rate; and

beyond a point may actually decrease. Consequently, it may not be in the interest of the

bank to raise interest rates in response to excessive demand for loanable funds; instead

banks can ration credit and thus increase allocative efficiency.

Another way through which banks can increase allocative efficiency of capital is by

engaging in relationship lending. Banks engage in both relationship and transactional

lending. Relationship lending refers to the development of sector-specific expertise and

long term financing arrangements with firms. Such an agreement is most beneficial to

firms with no past credit history, collateral or credit constrained firms. Transactional

15Assuming good borrowers prefer cheaper financing16Since, if successful, risky projects would yield higher returns.


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lending (like commercial papers, equity and bond markets), on the other hand, involves

arms-lengthlending based on readily observable information about the firm17.

Acknowledging the important role of small firms in an economy, Petersen and Rajan

(1995) argue that in an excessively competitive market structure, banks would not be

willing to enter into relationship lending and thus constraint finance for young firms.

When a firm is young or distressed, the potential for future cash flows may be high, while

the current state of cash flows is low. When evaluating a project, creditors (banks) should

not only consider the current cash flows but also the future stream of profits it may

generate.

However, as we now know, banks also face a pool of risky borrowers and young firms

are particularly risky due to the element of uncertainty attached to their existence. In such

a scenario, banks, in a competitive credit market would be forced to increase lending

rates till the uncertainty is resolved (the young firm establishes herself). To the extent that

banks charge a higher rate of interest, it would also invite a riskier pool of applicants

(adverse selection) and also bring about a preference shift from risk averse to risk taking

behavior. To circumvent this adverse selection problem, banks would be induced to

ration credit. All this would eventually result in limiting finance opportunities for young

firms.

The thought that relationships and competition are incompatible is not only restricted to

the credit market but echoes in other sub-disciplines of economics as well. For instance,

labor economist claim that a firm is more reluctant to invest in training workers in a

competitive labor market unless they post a bond, since workers can threaten to quit or

demand a competitive salary once they have been trained. Similarly, a competitive credit

market would be unwilling to enter into relationship lending with young firms for if the

young firm in question is successful and is established in the market, she can be lured

away by other banks at better deals, leaving the current bank to be at the receiving end.

17For example, funds raised by issuing debt or equity.


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In fact Hoshi, Kashyap and Scharfstein (1990) documented that high quality Japanese

firm moved away from their banks when the domestic bond markets were liberalized.

A bank with market power, on the other hand, can share in the future surpluses generated

by the firm through the future rents she is able to extract. The banks can backload interest

payments over time subsidizing the firm when young or distressed and extracting rents

later. Consequently, a bank in a concentrated market structure may be more willing to

engage in relationship lending than her counterpart in a competitive structure. Petersen

and Rajan also demonstrated that the surplus extracted in the future does not affect the

firms choice between projects (as in risk averse or risky project), but th e lower initial

rate give the firm an incentive to take safe projects initially when applying for loan and

thus increasing allocative efficiency.

Of the two theoretical models outlined above, while the Petersen and Rajan model

explicitly assumes banks to have a certain degree of market power in order to engage in

any kind of relationship lending, the Stiglitz and Weiss model implicitly assumes banks

to have market power. I say implicit because the model itself does not take into account

competition among banks, however for a bank to ration credit, it ought to have some

degree market power. This is so because in an excessively competitive market for loans

and deposits, banks would be constrained to break even on a period by period basis and

would have to passively sit back and follow the free market mechanics.

Then, for a moment, if we do assume that market power actually translates into allocative

efficiency and at the same time ensure stability, can we generalize these results? At this

point, I wish to remind the readers that even though the results point towards limiting

competition in the banking industry, the models themselves have been built on certain

assumptions. While these assumptions stand true or not is an empirical issue and as such

would be discussed in the next chapter, for the time being we continue investigating

additional factors which lead us to a concentrated banking industry.


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3.2.1: Market Power and Banking- The Debate Continued.

Banking markets have a natural tendency to become concentrated because of the intrinsic

indivisibilities in the financial system (refer chapter 2). Put differently, firm size matters

in banking. Even if one believes that concentration and large firm size can be bad for

competition since they maintain and make use of market power to the disadvantage of

consumers, concentrating on consumer welfare alone would amount to a partial analysis

of the problem. Instead, the relevant question for economists to analyze should include

the bigger picture and take into account producers benefit as well. As we now know that

banking markets suffer from inherent indivisibilities (scale economies and asymmetric

information), which also translates into increasing returns to scale, reducing market

power would also mean lower profits for banks. However, in order to cover up financially

to overcome such indivisibilities, banks need to exercise some market power or in other

words need to work on higher than competitive returns. Thus, the degree of concentration

in banking markets alone is not a sufficient indicator of how competitive the market is. In

fact, recent literature on bank competition and industrial organization alike has

recognized this fact and has proposed to focus on issues such as contestability, instead of

inferring results based on the degree of concentration alone. Following such footsteps, I

further elaborate on factors which make concentration come naturally to the banking

markets and also why market power might not be harmful.

A critical factor in any market which governs the competitiveness of a sector is thought

to be barriers to entry and exit. One of the reasons why contestability is thought to be best

from a social viewpoint is because in the absence of any entry barriers, firms can come in

quickly and take away any excess profits which a monopolist might be earning (in other

words, the hit and run phenomenon). However as we shall see, in our case, whilst some

entry barriers come physically to this sector, others have been created just to promote

social welfare.


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3.2.2: Entry Barriers in Banking

Barrier to entry in any market is defined by the degree of sunk cost investments in thatparticular market. Entry into the financial sector requires substantial costs which tend to

be sunk to a high degree. For instance, retail banking is very much based on the concept

of branch networking, which requires investments sunk to a high degree. Even where,

banks operate electronically (e-banks), investment in reputation and trust building

requires substantial investment, which might turn out to be sunk. As is well know from

the literature on strategic entry deterrence, sunk cost technologies put new entrants on a

cost disadvantage compared to incumbent firms and so might deter free entry into this

sector. Particularly investments in building up customer goodwill and reputation such as

advertising or developing client network may be irreversible upon exit.

Another type of entry barrier, especially in retail banking may exist because of demand

side peculiarities. Universal banks which offer one stop shop experience compared to

other more specialized institutions may give them switching cost advantage over other

single product banks, giving them the necessary scale through diversification. Although,

this does not act as an entry barrier, the fact that switching banks is harder due to account

information and other personal data make it more complex and difficult for customers to

switch banks. Moreover, differentiation of financial products and services has made

direct price and service comparison even more difficult for customers.

Entry barriers also restrict exit. Once a bank has entered the market, sunk investments

make it unattractive to exit when profit opportunities are vanishing because assets can

only be sold off with a loss. In case of banks, assets refer to loan it has made out toentrepreneurs!

Another significant entry barrier in the banking industry is regulation. Banks are one of

the most highly regulated industries in the world due to their fragile nature. Public

regulation, in general, is justified by market failures that can come from (a) presence of


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market power (b) the presence of externalities or (c) asymmetric information between

buyers and sellers. However, the official justification for regulation in the banking

industry comes from the necessity of providing a safety net for banks to protect

depositors from the risk of failure of their banks (financial contagion, section 3).

For such reasons, entry into the financial system, particularly in banking and insurance is

regulated in almost all countries. For example, banks have to be charted by a regulating

authority is a common norm now in most countries around the world. Additionally, in

some countries, certain type of banks like development banks or export-import banks get

preferential treatment compared to others, giving them certain cost advantages. Host

country regulators may also act demandingly when allowing foreign banks to operate in

their country, like requiring them to setup headquarters or branches in that country

Yet another barrier to entry thought to exist in the banking sector is adverse selection.

Dell Ariccia et.al. (1999) develop a model similar in spirit to the one developed by

Shaffer to demonstrate that new entrants in the financial system would face adverse

selection as a barrier to entry. The authors characterize the equilibrium under Bertrand

competition and demonstrate that an equilibrium where the third bank enters does not

exist.

In order to get this result, the authors assume that banks face uncertainty about the

creditworthiness of the borrowers ex-ante. If they obtain information about borrowers

after lending to them, they are able to reject riskier borrowers when re-financing.

Potential entrant banks will face an adverse selection problem in that new entrants will be

unable to distinguish new borrowers from old ones who have been rejected by their

previous bank. Put differently, using Bains terminology, a third potential bank faces

entry blockaded and is unable to penetrate the market without incurring losses. The

reason is that a third potential bank considering entry faces a significantly different pool

of borrowers than the two incumbents. Also, given that banks compete in Bertrand

fashion, incumbent banks profits from its new customers are already zero and so the


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potential pay-off from entry by a third bank is unambiguously worse than the two

incumbents.

However, one can obviously question these results on the basis that the authors do not

take into account the timing of entry and of competition. if we were to accept that entry

may be a decision that takes place over a long period and is necessarily a decision made

prior to competition, even then adverse selection posses as an entry barrier. This is so,

because as bank 3 enters she not only tries to lure away old customers of the incumbent

banks, she also faces the rejected pool of applicants from the established players

(incumbent banks). To the extent that incumbent banks are making zero profits on new

customers, the entrant not only makes the same on this segment, but also has to deal with

the rejected pool of applicants. Hence bank 3 must make negative profits overall, if it

ever enters. Put simply, the entrant bank face higher cost of operation during this entry

period than incumbent banks do, which leads to the deterred entry result.

Thus banks which have been in the market long enough would have a certain information

advantage over these new entrants by virtue of their established relationships with

borrowers seeking credit. This can put new entrants in a worse position relative to the

incumbent and may therefore lead to diminished or deterred entry.

In fact the results obtained above are not in isolation. A large literature has recognized

that, in a variety of settings, perfect competition cannot be attained in presence of

asymmetric information. For example, Schmalensee (1982) analyzes the case where

buyers are uncertain about product quality of each particular producer and can resolve

that uncertainty only by buying and trying the product. He shows that in such a setting an

incumbent firm may be immunized from competition by potential entrants, by virtue of

the superior information consumers have about the incumbents product. One of the mainpoints of this article is to explore a new channel through which imperfect information

undermines competition.

In the context of banking, an article similar in spirit is done by Broecker (1990), which

analyzes a competitive credit market where banks have the ability to perform binary


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creditworthiness tests on applicant firms and offer credit conditional on the realization of

this test. Broecker finds that as long as this test is imperfect and independent across banks

performing it18, increasing the number of banks can have adverse effects on the

equilibrium interest rates obtained. In his model, this effect arises because with more

banks performing independent tests, the average creditworthiness of firms that pass at

least one test is decreasing in the number of banks. whenever a firm accepts the highest

possible interest rate offer, it must have been rejected by all other banks and therefore

represents a very bad risk on average, consistent with the winners curse argument and the

credit rationing theory.

Consequently, barriers to entry and the respective indivisibilities in the banking system

warrant us to believe that not only does concentration come naturally to this sector but is

also necessary and beneficial. Then the appropriate question no longer remains whether

market power is good or evil for banks, but rather how much market power is needed to

achieve the desired goals of stability and efficiency. In such a scenario, the debate

essentially acquires a two dimensional face with respect to market power. That is, either

the banking sector can turn towards a monopolist market structure with just one bank

operating or the sector can reflect a oligopolistic market structure with a few firms

operating simultaneously.

3.3.3: Monopoly and Banking

As far as the issue of monopoly in banking is concerned, though a monopolist bank may

perform well on the stability front in that would be able to absorb any liquidity or credit

shock in the system, it would not be able to achieve the desired efficiency levels.

Remember from our discussion so far that in order to achieve high allocative efficiency,

banks screen and monitor projects which they have funded. A monopolist bank, realizing

her position, would screen excessively19, resulting in lower credit supply in the market.

18For example, each bank would have its own credit scoring model.19Since monopolies charge a higher rate of interest, they would screen excessively in order to mitigate moralhazard effects, For example, see Guzman (2000).


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This would have a negative impact on entrepreneurship and slow down firms investment

in research and development leading to a slower pace of technological innovation and

productivity growth20.

Higher lending rates would also slow down firms investment in research and

development, thus slowing down the pace of technological innovation and productivity

growth. Lower supply of loanable funds coupled with higher lending rates, should also be

reflected in a slower process of capital convergence to the highest levels of income per

capita. Also, though not explicitly modeled in the works of Petersen and Rajan, a

monopoly bank would intuitively not engage as much in relationship lending as would

banks in a concentrated banking system21.

Additionally, a monopoly banking system would not be able to achieve as much

productive efficiency as a comparatively less concentrated banking system would. The

idea of a single bank, like other monopolies, would introduce an element of X-

inefficiency or organizational slack in the firm in the sense that their incentive to innovate

would be lower than for firms exposed to competition.

Finally, a monopolist bank would also introduce agency problems such as the principle

agent problem and moral hazard in the system. Given the fact that shareholders and

depositors of a bank are displaced and small, a monopolist bank manager would not

strive hard enough to ensure maximum returns are achieved from inve

economics of market power

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