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OSAM MARK
PG/M.Sc/09/54338
IMPACT OF COMPETITION ON THE PROFITABILITY
OF COMMERCIAL BANKS IN NIGERIA
FACULTY OF BUSINESS ADMINISTRATION
BANKING & FINANCE
Chukwueloka.O.
Uzowulu
Digitally Signed by: Content manager’s
Name
DN : CN = Webmaster’s name
O= University of Nigeria, Nsukka
OU = Innovation Centre
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IMPACT OF COMPETITION ON THE PROFITABILITY OF
COMMERCIAL BANKS IN NIGERIA
BY
OSAM MARK
PG/M.Sc/09/54338
DEPARTMENT OF BANKING AND FINANCE
FACULTY OF BUSINESS ADMINISTRATION
UNIVERSITY OF NIGERIA, ENUGU CAMPUS
DECEMBER, 2015
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IMPACT OF COMPETITION ON THE PROFITABILITY OF
COMMERCIAL BANKS IN NIGERIA
BY
OSAM MARK
PG/M.Sc/09/54338
BEING AN M.Sc DISSERTATION PRESENTED TO THE DEPARTMENT OF
BANKING AND FINANCE, FACULTY OF BUSINESS ADMINISTRATION
UNIVERSITY OF NIGERIA, ENUGU CAMPUS.
IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD
OF A MASTER OF SCIENCE (M.Sc) DEGREE IN BANKING AND
FINANCE.
SUPERVISOR: PROF. CHUKE NWUDE
DECEMBER, 2015
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CERTIFICATION/APPROVAL
This is to certify that this research work on the Impact of Competition on the
Profitability of Commercial Banks in Nigeria (2005 – 2013) carried out by OSAM,
MARK under supervision, has satisfied the necessary requirements for the award of
the Master of Science Degree (M.Sc) in Banking and Finance of the University of
Nigeria, Enugu Campus.
………………………..
……………………..
Professor E. C. Nwude
Date
(Supervisor)
………………………..
……………………..
Professor E. C. Nwude
Date
(Head of Department)
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DECLARATION
I, Mark Osam, a Postgraduate Student in the Department of Banking and Finance
with Registration No. PG/M.Sc/09/54338 do hereby declare that the work embodied
in this research thesis is original and has never been submitted either in part or in full
for any Diploma or Degree of this University or any other Institution of Higher
learning.
……………… ………………..
Mark OSAM Date
PG/M.Sc/09/54338
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DEDICATION
I dedicate this work to my wife, Mercy D. Osam, who agreed to marry me despite
her several other options and to all my friends in our Imanna-Yok Association,
Ohumuruktet, who may never have this privilege of completing an academic
research work.
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INSPIRATION
In completing this research work, I drew so much inspiration from the achievements
of my academic mentor, Dr. Eze A. Eze, who could effortlessly traversed academic
hurdles in Economics, Banking and the Legal Profession. Ofem Ofegobi
Balinwo,who as a boyhood mentor who has grown to show the world his ingenuity in
strategic thinking, leadership skills, academic brilliance and for never ceasing to
remind me of my academic potentials by constantly challenging me to forge ahead.
Aya Matthew Oguni serves as my village role model as he is the only youth that
never saw the four walls of a Secondary School but could effortlessly write and pass
the SSCE in 1990. To him being financially handicapped has never dimmed academic
brilliance.
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ACKNOWLEDGMENT
Acknowledgments are usually one of the most difficult sections to write in research
work such as this. The reason is because it is difficult to concisely mention all the
people who have assisted in one way or the other in the successful completion of the
work. It is even more difficult to stop mentioning people whose love, attention and
encouragement should be placed on record for recognition purposes. At the
preliminary stages of this work, I had to change my research supervisors from Prof. C.
U. Uche to Prof JUJ Onwumere when the earlier had to proceed on his sabbatical.
Combining the duties of an incumbent Head of Department, Banking and Finance
with the voluminous research materials of several graduating students could not allow
Prof Onwumere to conclude my research supervision. The incumbent Head of
Department, Banking and Finance, Prof. Chuke Nwude had magnanimously assumed
this responsibility and graciously completed this. For all the fatherly role, advice,
directives and supervision, I remain eternally grateful.
Combining a successful professional banking career with great academic pursuits has
never been a mean feat as it is clearly stressful to successfully combine both.
However, this stress was ameliorated by the attention I received from colleagues like
Charles Ubagwu, Daniel Ukwu, Martins Ezeamama, Eze A. Eze, Isreal Igiri, Saheed
Laifa, Chinazu Akonye, Asian Umobong and several others, too numerous to
mention. I owe them this note of gratitude.
Though far away in Ohumuruktet village, my friends have always been a source of
great joy and motivation to me, always interested in my academic exploits even
though majority of them may never have the opportunity to complete an academic
research work. I specifically remember Ejukwah Amah, Ojen Ebey, Isua Ayang,
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Ayang Sunday, Gabriel Sunday, Sunday Oji, Okon Matthew and William Agbor;
these are people with natural intelligence but whose zeal for academic heights may
never be fully achieved because of our traditional poverty.
My family members took turns to bear the burden of my frequent absence from home
while in search of this Golden Fleece. The roles played by my daughters, Nsiyan
Osam and Macha Osam, who will constantly ask me if am leaving home again, are
greatly recognized here. My Son and Heir apparent, Phinsi Osam, who I hope to hand
over this baton, in further pursuits of academic heights is majorly noted too. My other
siblings and family members are not missed out here: Rose Kirian, Catherine Okimba,
Koko Dickson, Ndondo Asoha, Hillary Ogbu and my life protégée, Okimba Adomi
Ayang – Bee Jay and many others too numerous to mention. To them, I will always
remain a role model.
Dr. Okorn Osam remains my symbol,both of political leadership and family head.
This is a man who assumed headship ofthe entire family at a very tender age, may be
when he too needed guidance and has steered the ship of statesmanship so admirably
since early 1977. He has been my adviser, guardian and leader. I cannot thank and
appreciate him enough.
Whatever I am today, I owe all the gratitude and appreciation to just one woman, my
mother, apart from God almighty whose glory is for evermore. Many other people call
their mothers by pet names such as mummy, but, I still call and address mine as
Mama. A very rare and special gem who sacrificed so much, threaded our traditional
path of poverty and penury for so long, just in an effort to make me a better person in
our society, Ma Lucy P. Osam, I will always be your son. I sincerely lack the
appropriate words to convey my hearty appreciations to her but, if it pleases God to
spare my life further, I promise to repay her this debt, one day.
In spite of all the contributions, assistance and encouragement that I have received in
the course of this work (both the sources I referenced, acknowledged and others too
numerous to mention) I bear alone the full responsibility for the contents of this
research work and will remain answerable even to posterity for all the errors,
omissions and mistakes inherent in this work.
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LIST OF TABLES, GRAPHS AND CHARTS
Table 2.1 Interpretation of the PR H Statistic for Market Structures 33
Table 2.2 H Statistic for the Intensity of Competitiveness of some
African Countries 34
Table 2.3 Estimates for Efficiency Rating using the Profit
Maximization Model in some EU Countries 38
Table 2.4 Concentration Index for some African Countries using the
K Concentration Index 43
Table 2.5 Interpretation of Market Equilibrium position using the
Bresnahan Model 48
Table 2.6 H Statistic for some African Countries using the PR Model 61
Table 4.1 Summary of Aggregate Values of Variables 100
Table 4.2 Summary of Average Values of Variables 101
Table 4.3 E View Results used for Descriptive Analysis 102
Table 4.4 Summary: Average Values of PBT and Market Share 104
Figure 4.1 Chart of Profitability and Market Share of Commercial Banks
in Nigeria 105
Figure 4.2 Graph of Profitability and Market Share of Commercial Banks
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in Nigeria 106
Table 4.5 Summary: Average Values of PBT and Efficiency 106
Figure 4.3 Graph of Profitability and Efficiency Ratios of Commercial Banks
in Nigeria 108
Figure 4.4 Graph of Profitability and Efficiency of Commercial Banks
in Nigeria 108
Table 4.5 Summary: Average Values of PBT and Concentration 109
Figure 4.5 Chart of Profitability and Concentration levels of Commercial Banks
in Nigeria 111
Figure 4.6 Graph of Profitability and Concentration of Commercial Banks
in Nigeria 111
Table 4.7 Correlation- Results 112
Table 4.8 Results of Pooled OLS Regression Analysis 113
ABSTRACT
That the Banking Industry in Nigeria has always been profitable has never been in
doubt. Again, that the Nigeria banking industry has been a very competitive one is
also not a matter for contention as the result of several researchers measuring the
competition in the banking industry have sufficient empirical evidence to substantiate
this theory, however, what has recently become a contentious issue is to determine
what really drives banking profitability in the face of this cut-throat competition in
Nigeria. Not even the banking consolidation reforms introduced in Nigeria by the
erstwhile Governor of the Central Bank of Nigeria, Professor Charles C. Soludo, in
2005 which highlighted the unprecedented competition in the Nigerian banking
industrycan be agreed to the major determinate of banking profitability in Nigeria.
Generally, the impact of competition on the profitability of commercial banks in
Nigeria has been a subject of great scholarly inquiry and continues to occupy a large
body of empirical research. Competition in the banking industry is necessary as it
promotes economic growth by increasing firms’ access to external financing,
lowering the costs of providing banking products and services, managing and
mitigating banking risks, mobilizing savings and investment opportunities and
adopting efficiency strategies for improving profitability. Petersen and Ranjan (1995)
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show theoretically that Commercial banks that wield substantial market share are
more profitable in developed economies as they can lend even to young firms whose
credit records may be opaque, hence leading to high loan volumes and substantial
increase in both economic activities and economic growth. However, Cetorelli and
Gamberra (2001) argue that, there is compelling evidence to suggest that the
profitability of commercial banks in most developing economies (for which Nigeria is
one) is a direct function of its banking efficiency and other ancillary variables and has
no direct relationship with the market share of firms.Hence, the profitability of
commercial banks in Nigeria can only be placed at the center of any developmental
economic agenda, if it combines optimally the determinates of banking profitability
such as market share, efficiency and concentration of commercial bank branches to
respond to the dynamic changes in economic conditions, especially, those that affect
delivery of financial services. Our major objective in this research is therefore, to
resolve the dilemma between the conflicting theories highlighted in the Structure
Conduct Performance Hypothesis - SCP (which propagates the ideals of significant
market share) and the theories of Efficiency Structure Hypothesis -ESH, (which gives
credence to the significance of banking efficiency) in assessing the impact of
competition on profitability of commercial banks in a developing country like
Nigeria.
TABLE OF CONTENTS
Title Page i
Certification/Approval ii
Declaration iii
Dedication iv
Inspiration v
Acknowledgment vi
List of Tables, Graphs and Charts vii
Abstract ix
Table of Contents x
Chapter 1 Introduction
1.1 Background of the Study 1
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1.2 Statement of the Problem 7
1.3 Objectives of the Study 9
1.4 Research Questions 9
1.5 Research Hypotheses 9
1.6 Scope of the Study 10
1.7 Significance of the Study 12
1.8 Limitations of the Study 15
References 16
Chapter 2 Review of Related Literature
2.1 Introduction 23
2.2 Theoretical Review of Related Literature 25
2.2.1 Market ShareModels 30
2.2.2 Efficiency Models 34
2.2.3 Bank Concentration Models 38
2.2.4 Drivers of Competition in the Banking Industry 42
2.2.5 Competition that Causes Economic Crises 52
2.3 Empirical Review 59
2.4 Review Summary 63
References 66
Chapter 3 Research Methodology
3.1 Research Design 76
3.2 Nature and Sources of Data 77
3.3 Population and Sample Size 77
3.4 Model Specification 78
3.5 Description of Research Variables 80
3.5.1 Dependent Variables 81
3.5.2 Independent Variables 83
3.5.3 Intervening Variables 86
3.6 Techniques for Data Analysis 89
References 91
Chapter 4 Presentation and Analysis of Data
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4.1 Introduction 96
4.2 Presentation of Data 97
4.2.1 Descriptive Statistics 98
4.3 Results of Correlation Analysis 108
4.4 Results of Regression Analysis 113
4.5 Test of Hypotheses 114
4.5.1 Test of Hypothesis 1 115
4.5.2 Test of Hypothesis 2 116
4.5.3 Test of Hypothesis 3 117
References 119
Chapter 5 Summary of Findings, Conclusion and Recommendations
5.1 Introduction 123
5.2 Summary of Findings 123
5.3 Conclusion 124
5.4 Contribution to Knowledge 125
5.5 Recommendations 126
5.6 Recommended Areas for further Research 128
References 129
Appendices
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Competition in the banking industry has been a subject of great scholarly inquiry and
continues to occupy a large body of empirical research. That the Banking Industry in
Nigeria has always been profitable since the early 1990s has never been in doubt.
That the Nigeria banking industry has been a very competitive one is also not a matter
for contention as the results of several researchers measuring the competition in the
banking industry have sufficient empirical evidence to substantiate this theory,
however, what has recently become a contentious issue is to determine what really
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drives banking profitability in the face of this cut-throat competition. Not even the
banking reforms introduced in 2005 which triggered unprecedented competition in the
banking industry in Nigeria can be agreed to the major determinate of banking
profitability in Nigeria. The reforms generally entailed the upward review of the
minimum capital requirement of banks from N2billion to N25billion (an increase of
approximately, 1,150%), a decrease in the number of commercial banks operating in
Nigeria from 120 in 1993 to about 24 commercial banks post consolidation in 2010
and a dilution in the ownership structure of most commercial banks as they
subsequently became publicly quoted companies on the Nigerian Stock Exchange
(NSE).
Generally, the impact of competition on the profitability of commercial banks in
Nigeria has been a subject of great scholarly inquiry. Banking competition promotes
economic growth by increasing firms’ access to external financing, lowering the costs
of providing banking products and services, managing and mitigating banking risks,
mobilizing savings and investment opportunities and adopting efficiency strategies for
improving profitability. Petersen and Ranjan (1995) show theoretically that
Commercial banks that wield substantial market share are more profitable in
developing economies as they can lend even to young firms whose credit records may
be opaque, hence leading to high loan volumes and substantial increase in both
economic activities and economic growth.
However, Cetorelli and Gamberra (2001) argue that, there is compelling evidence to
suggest that the profitability of commercial banks is a function of its banking
efficiency and other ancillary variables and has no direct relationship with its market
share. Hence, the profitability of commercial banks can only be placed at the center of
any developmental economic agenda if it combines optimally the determinates of
banking profitability such as market share, efficiency and concentration of
branches of the commercial bank to respond to the dynamic changes in economic
conditions, especially those that affect delivery of financial services. Our major
objective in this research is therefore, to resolve the dilemma between the conflicting
theories discussed in the Structure Conduct Performance Hypothesis - SCP (which
propagates the ideals of significant market share) and the theories of Efficiency
Structure Hypothesis - ESH, (which gives credence to the significance of banking
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efficiency) in assessing the impact of competition on profitability in a developing
country like Nigeria.
From public policy perspective, competitiveness of the banking sector is agreed to
represent a socially optimal target, since it reduces the cost of financial intermediation
and improves delivery of high quality services thereby enhancing social welfare.
Banking competition also promotes economic growth by increasing firms’ access to
external financing (Beck, Demirgüç-Kunt and Maksimovic, 2004; Pagano, 1993).
However, Petersen and Ranjan (1995) show theoretically that banks wielding
substantial market share tend to lend to young firms whose credit records may even be
opaque, hence leading to high loan volumes.
In practice, Cetorelli and Gamberra (2001) argue that, although, concentrated banking
systems offer growth opportunities for young firms, there is strong evidence of a
general depressing effect on growth associated with banks’ exercise of market share
and this impacts all sectors and firms in the economy. Hence, competition in banking
should be placed at the center of any public policy agenda since it has the mechanism
to respond to the dynamic changes in economic conditions, especially those that affect
delivery of financial services. Relevant literature on the measurement of competition
in the banking industry may be divided into two broad mainstreams, the structural
approach and the non-structural approach (Mugume, 2010). The structural approach
to modeling competition is majorly made up of the structure-conduct-performance
(SCP) paradigm and the efficiency structure hypothesis (ESH) as well as a number of
other formal approaches which all have their roots in industrial organization theories.
However, sufficient theoretical and empirical evidence abounds that confirm that both
the SCP, ESH and the other market concentration indexes such as the Herfindahl-
Hischman index alone cannot be used to measure industry wide banking competition
because they have deficiencies that inhibit their effective use as a measure of banking
competition. Mugume (2010) stated some of these deficiencies to include a country’s:
Macro-economic performance
Financial stability
Form and degree of taxation of financial intermediation products
Quality of information and judicial systems
Scale of banking operations
Risk preferences
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The author opines that because of the highlighted deficiencies of the Herfindahl-
Hischman index, the use of these concentration measures present a poor indicator for
the degree of competition in the banking industry especially, for developing countries,
such as Nigeria (Mugume, 2010). However, concentration ratios as measures of
competition do not also provide adequate and conclusive explanations of actual bank
profitability and may lead to wrong inferences on competitive conditions (Hausman
and Sidak, 2007). Instead, Baumol (1982) opines that banking competition should be
assessed based on banking market contestability arising from the presence or absence
of entry barriers into the industry. Mwenda and Mutoti (2011) remedied this bias by
measuring banking competition in the Zambian banking sector using the H statistic
model developed by Panzar and Rosse (Simpasa, 2013). Although, there was a
significant improvement over the results of Baumol (1982) using banking
concentration ratios to measure the impact of competition, the authors did not
condition the competitive index on changes in market conditions brought about by the
entry of new foreign banks in the recent years and the privatization of the Zambian
National Commercial Bank (ZNCB) that took place in 2007 (Simpasa, 2013).
Profitability of Nigerian commercial banks has generally been buoyant, driven by
earnings on bank loans, commission n turnover, income from trading treasury
securities, realized gains on foreign exchange transactions and fee income which have
all contributed significantly to these commercial banks’ profits. Banks’ return on assets
(ROA) and the net interest margin (NIM) are the major proxies used to gauge banking
profitability and the intensity of competitive pressures on these commercial banks.
Depending on the market share of a bank in input and output markets respectively, it
may be able to increase output prices (lending rates) or decrease input prices (deposit
rates) with a view to increasing its profitability. Bank management can select the
combination of inputs (time deposits, fixed deposits, savings account deposits) and
outputs (loans) at which profits can be maximized (DeBandt and Davis, 2000).
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In order to avoid stating the obvious and to clarify our motives further, we start by
asking why a bank would not be able to maximize her profits. Let us consider four
issues related to profit maximization: (Berger, 1995).
(a) The role of diversification and risk preferences of the bank;
(b) The problems between shareholders and bank management;
(c) Imperfect competition and;
(d) Inefficient use of inputs and outputs.
A first consideration relating to bank profit maximization concerns the concept of risk
and its diversification. Shareholders will usually prefer to balance their appetite for
maximizing expected profits and minimizing costs with the amount of risk they are
willing to take. Abstracting from speculative motives, shareholders are generally
assumed to be indifferent to the distribution of profits, receiving a return on their
investment in the bank either through an increase in the bank’s share price or through
dividends received. If all the banks operating in the economy share the same risk-
return preferences, or if the risk-return relationship can be described by some
relatively simple homothetic continuous function, then there is no serious problem
with the fact that we may have to control for a bank’s risk preferences. Recent works
by DeYoung (1998) have tried to incorporate risk into a bank benchmarking exercise.
Given that this type of work is still in its infancy in developing countries, such as
Nigeria, we refrained from including risk and risk preferences in this research work.
Instead, we adopted other control variables such as bank regulation and bank
reputation that aim to proxy for banks’ risk-return preferences.
A second consideration relating to banks’ profit maximization, concerns incentive
structures. Even risk-neutral shareholders who are well-diversified may have
problems translating their claims on bank profits into actions required to maximize
revenue and minimize costs. In the absence of complete information, principal-agent
theory states that shareholders are unable to adequately monitor bank management
and that the resulting managerial discretion may induce sub-optimal behavior, i.e.
profits are not maximized and/or costs are not minimized (Berger and Humphrey,
1997). As long as shareholders cannot monitor and penalize bank management, the
latter may show expense-preference behavior or if the bank management is highly
risk-averse, it can adopt any other strategy that tends to reduce the profitability of the
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bank (Hannan and Mavinga, 1980). This means that the asymmetric information
between principal and agent that was once used by Diamond (1984) to explain the
profitability of banks from a reduction in audit costs for lenders to non-financial can
also be used to explain why banks themselves may also suffer from moral hazards and
other compensation incentive problems in their profitability drive (Diamond, 1984).
Firstly, very few studies have attempted to test empirically the impact of principal-
agent conflicts on the performance of banks even in developed countries and
specifically in European banks. (Molyneux and Forbes, 1995) Translations into
empirical tests of the principal-agent conflicts described above where hidden actions
by or hidden knowledge of bank management which resulted in suboptimal
profitability measures. Secondly, to the extent that the principal-agent relationship
results in moral hazard conflicts, this will only create problems if the principal (i.e.
the shareholders) cannot insure himself against excessive risk-taking by the agent i.e.
the bank management (Meyer and Mugume, 2004). A vast amount of literature exists
on ways to minimize the negative effects of these principal-agent problems but have
not been considered in this research work.
Thirdly, price and non-price competition, the substitutability of bank’s products and
the contestability of banking markets may also serve to ensure that a bank’s optimal
profitability is not achieved by putting competitive pressure on its management,
provided that the bank’s management compensation is not performance-based
(DeBandt and Davis, 2000).
Whether compensation incentive problems are as important in determining why banks
themselves may also suffer from moral hazards as in developed banking economies as
there are in developing economies is still questionable (Molyneux and Forbes, 1995).
Although, these identified compensation incentive problems may lead to suboptimal
performances by banks, which is an anomaly to the cardinal objective in being in
business, the extent to which these incentives problems affect a developing country
such as the Nigeria banking industry is unclear. There are quite a few reasons to
suspect that the incentive problems that can cause a bank to make lesser profits or
experience above-minimum average costs are significantly different from bank to
bank, or from country to country. This is because the thin line of separation between
ownership and control is highly similar for commercial banks across developed
countries, especially in Europe (Goldberg and Rai, 1996). Therefore, even if
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compensation incentives constraints can help explain bank performance, empirical
testing of these incentives to determine whether they can explain differences in bank
performance is difficult to achieve and their empirical results to date, have so far been
in conclusive. Also, commercial banks’ profitability is usually related to changes in
the environment and the behavior of their competitors (Molyneux, Lloyd-Williams
and Thorton, 1994; Goldberg and Rai, 1996; Levine, Laoyza and Beck, 2000).
Therefore, another consideration relating to banks’ profit maximization relates to the
market share of the individual commercial bank (Berger and Hannan, 1998).
Economic theory also tells us that in a perfectly competitive situation, profit
maximization is equivalent to cost minimization. In practice however, we do not
necessarily observe maximization of profits and/or minimization of costs. Of course,
exogenous factors such as regulation or (economic) shocks can cause suboptimal
performances for commercial banks. To the extent that these exogenous factors do not
have similar effects on both cost minimization and profit maximization, they can
drive a wedge between the two (Hannan and Mavinga, 1980). Imperfect market
structures can cause a situation where commercial banks’ profits are maximized at an
output level where average costs are no longer minimized, thus leading to achieving
sup-optimal profitability peaks by commercial banks (Vivex, 2001). This sub-optimal
profitability achievement can thus be used to explain changes in profitability levels
over time for firms as well as for commercial banks.
A bank may also produce at lower costs and with a higher profit than other banks if it
makes better use of its input resources and transforms them into outputs in the
cheapest possible way. In the long run, every bank has to produce efficiently in order
to survive banking competition. This brings us to the next factor driving
maximization of banking profits in Nigeria, which is banking efficiency.
The competitive indices for efficiency offer a practical perspective on the
understanding of banking competition in Nigeria and its policy implications. The
broad conclusion from several research analyses is that over a longer period of time,
commercial banks efficiency will begin to decline, underpinning the growing intensity
of competition, particularly in post financial reform periods (Mugume, 2010). This
suggests that the degree of competition may be higher for commercial banks before
banking reforms are introduced than after banking reforms are introduced in their
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economies. Also, that the degree of competition from other forms of financial
intermediaries (capital markets, non-bank financial institutions, insurance companies)
play a role in determining the degree of competition in banking system. It has also
been shown, theoretically as well as empirically, that the degree of competition in the
financial sector can matter in assessing economic development.
1.2 Statement of the Problem
In the face of slowing industry growth and so much competition, today’s commercial
banks are under tremendous pressure to grow organically by gaining a proportionate
portion of the market share. A financial system’s contribution to the economy
depends on the quantity and quality of its services and the efficiency with which it
provides them (Mugume, 2010). According to Mugume (2010), there are two
plausible theories to determining the market share of competing banks towards
measuring their profitability and it is crucial to determine which of these two theories
more accurately describes their behavior with increasing profits, since the economic
policy implications derivable from either of these theories are radically diverse. The
first theory postulates that an increase in banks’ profitability is directly related to the
total efficiency improvement in its operations, termed the Efficiency Structure
Hypothesis (ESH) theory.
The efficiency hypothesis further expatiates that an increase in the total revenue of
banks’ as a result of improved efficiency will certainly increase that banks’
profitability. The other theory, the Structure Conduct Performance (SCP) Hypothesis
explains that an increase in the profitability of commercial banks is caused by an
increase in the market share and that being in possession of a considerable share of
the market, otherwise classified as possessing market power is attributable to the SCP
Hypothesis (Smirlock, Gilligan and Marshall, 1984; Mugume, 2010).
Relevant literature also suggests that there exists a relationship between concentration
and efficiency and between market share and profitability, as already highlighted
above. These relationships have generated competing hypotheses. On the one hand,
the traditional collusion theorists, also called the structure-conduct-performance - SCP
hypothesis (Bain, 1951) postulates that banking concentration lowers the cost of
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collusion between firms and results in higher normal profits. On the other hand, the
efficiency theorists, proponents of the efficiency structure hypothesis - ESH
(Demsetz, 1973) postulated an alternative explanation for the existence of a positive
correlation existing between banking efficiency and profitability, affirming that only
the most efficient firms in any industry can attain greater profitability and
consequently their market shares can become more concentrated enhancing their
profitability. He, (Demsetz, 1973) concludes that, in such circumstances, the observed
positive relationship existing between concentration and profitability is spurious as it
simply proxies competition for an already existing positive relationships between
superior efficiency, market share and concentration. (Gibson and Tsakalotos,
1994).
This is the main problem that this research work helps to resolve - the dilemma
between the conflicting theories of structure-conduct performance hypothesis (SCP)
and the efficiency structure hypothesis (ESH) as to which of these theories really
drives profitability in Nigerian commercial banks. Is it the acquisition of a significant
market share or the adoption of an efficient banking approach that explains the
profitability of Nigerian commercial banks and other developing economies?
1.3 Objectives of the Study
The overall objective of this study is to empirically investigate the impact of
competition on the profitability of commercial banks in Nigeria. To achieve this
objective, the study strives to accomplish the following specific objectives:
1. Investigate the impact of market share on the profitability of commercial banks
in Nigeria.
2. Find out the impact of banking efficiency on the profitability of commercial banks
in Nigeria.
3. Investigate the impact of concentration on the profitability of commercial banks
in Nigeria
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1.4 Research Questions
This study strives to provide answers to the following research questions:
1. What is the impact of market share on the profitability of commercial banks in
Nigeria?
2. What is the impact of banking efficiency on the profitability of commercial banks
in Nigeria?
3. What is the impact of banking concentration on the profitability of commercial
banks in Nigeria?
1.5 Research Hypotheses
In order to achieve the above stated research objectives and also answer the research
questions formulated above, the following research hypotheses have been tested:
1. Market share does not have a significant and positive impact on the profitability of
commercial banks in Nigeria.
2. Banking efficiency does not have a significant and positive impact on the
profitability of commercial banks in Nigeria
3. Banking concentration does not have a significant and positive impact on the
profitability of commercial banks in Nigeria.
1.6 Scope of the Study
This study covers the period 2005 – 2013 and gathers data from about 13 out of the 24
existing commercial banks in the country. 2005 is chosen as the commencement year
for the scope of this study because it was the first year in which financial statements
of commercial banks were prepared after the banking consolidation reforms which
were embarked upon by the erstwhile Governor of the Central Bank of Nigeria -
CBN, Professor Charles Soludo in 2004. The consolidation reforms generally entailed
the upward review of the minimum capital requirement of banks from N2billion to
N25billion (an increase of approximately, 1,150%), a decrease in the number of
commercial banks operating in Nigeria from 89 to 24 (post consolidation) and a
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24
dilution in the ownership structure of most of these banks as most commercial banks
subsequently became publicly quoted companies on the Nigerian Stock Exchange.
(Nannyanjo, 2012). The financial year ending December 31, 2013 fits our terminal
date for the scope of this study because the data used in our analysis has already been
published by as of April 31, 2014. The 2004 financial reforms were also expected to
see to the emergence of a fewer number of commercial banks in Nigeria but with a
significant capital base. Mergers, acquisitions and other forms of business
combinations produced the resultant 24 commercial banks which triggered
unprecedented competition among the banks and the ultimate emergence of the five
big banks in Nigeria due to their huge capital base.
These banks are: First Bank of Nigeria – (FBN), Guaranty Trust Bank – (GTB),
Zenith International Bank – (ZIB), United Bank of Africa – (UBA) and Access Bank -
Access. Apart from these 5 big banks the other high efficiency emerging banks that
will be sampled in this study are: Ecobank International – (ECOBANK), Skye Bank –
(SKYE), First City Monument Bank – (FCMB), Union Bank of Nigeria – (UBN),
Diamond Bank – (DIAMOND), Fidelity Bank – (FIDELITY), Stanbic IBTC Bank –
(STANBIC) and Sterling Bank – (STERLING). These 13 banks are chosen out of
the 24 banks in the industry because in a recent study carried out by the Research
Department of FBN in 2013 comparing the market shares of commercial banks in
Nigeria for the financial year ending December 31, 2012 their combined value was:
(Appendix 1)
Total Assets (TA) 86% of Industry value
Total Deposits (TD) 86% of Industry value
Net Revenue from Funds (NRFF) 91% of Industry value
Operational Expenses (OPEX) 87% of Industry value
Profit before Tax (PBT) 94% of Industry value
From the analysis above, it is obvious that the other 11 commercial banks that do not
constitute a part of our sample merely control a minority value of the industry market
share as highlighted below:
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25
Total Assets (TA) 14% of Industry value
Total Deposits (TD) 14% of Industry value
Net Revenue from Funds (NRFF) 9% of Industry value
Operational Expenses (OPEX) 13% of Industry value
Profit before Tax (PBT) 6% of Industry value
Broadly speaking, our knowledge about bank behavior, bank pricing of their products
and services in Nigeria is still very limited. There is a gap in empirical work on
whether competition in the banking industry has really increased in this era of
financial reforms in Nigeria (post banking consolidation reforms of 2004) or not.
Although, there are good reasons to believe that changes in banking regulations may
also affect the relationship between competition and profitability, it is not within the
scope of this research work to consider the influence of banking regulations on the
profitability of commercial banks in Nigeria.
1.7 Significance of the Study
While there has been a rapidly growing literature on banking profitability issues in
developed countries, little attention has been paid to the profitability of commercial
banks in developing countries, yet there is an increasing recognition that financial
sector development is a top priority for sustained economic growth in developing
countries like Nigeria. This research work aims to contribute to the existing literature
by analyzing the impact of competition on the profitability of commercial banks in
Nigeria during the recent post consolidation era of 2004 generally and specifically to
the following researchers and stakeholders:
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26
a. Financial System Operators: The financial system of any economy is made of
its financial markets (commercial banks) and other financial institutions (discount
houses, insurance companies, bureau de change, stock broking firms, etc.) which
are central to its economic development and growth. Obviously, the financial
system tends to evolve around a strong banking system which can facilitate a
more efficient allocation of financial resources. The importance of a strong and
competitive banking sector in a country’s economic growth and development is
already well established in several banking competition literature (Beck, Levine
and Loayza, 2000). The efficiency theory highlighted in this research work if
adopted and implemented by the financial system operators will help to grow the
economy partly by widening access to external financing and channeling financial
resources to the economic sectors that need them most. (Mugume, 2010). A well-
developed financial system which results from a healthy competition in the
banking industry can also help an economy cope better with exogenous shocks
such as terms of trade volatility and move such nations away from natural
resource-based development to other competitive and viable economic growth
alternatives.
b. Bank Operators: It is necessary for every banking system to be competitive; this
is to ensure that banks are effective forces for financial intermediation, channeling
savings into investments that foster higher economic growth and other ancillary
functions of a commercial bank in an economy. However, it is also necessary to
monitor and control the impact of market share on the competitiveness of
commercial banks which is a major independent variable in measuring the impact
of competition on the profitability of commercial banks in Nigeria.
Bank Operators will therefore be more properly guided in adopting appropriate
strategies towards increasing their share of the market with a view to increasing
their profitability if they imbibe the recommendations in this research work.
c. Bank Regulators: A high degree of competition and efficiency in the banking
system can contribute to greater financial stability, product innovation and access
by households and firms to financial services which can in turn improve the
prospects for economic growth. In this respect, there is a real concern that a
monopolistic or oligopolistic, inefficient and fragile banking sector in Nigeria is a
major hindrance to economic development. Identifying the kind of reforms and
environments that may help to promote competition and efficiency in Nigeria’s
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27
banking system is therefore very important to the regulators of the industry as
highlighted in this research work. In the light of most recent regulatory changes
affecting the United States of America (USA) financial industry, the policy
relevance for USA regulators is more current than ever. Such regulatory changes
continue to have a significant impact on the market share of the banking industry
and on bank’s competitive conduct. A deeper analysis of the economic role of
bank competition which has been highlighted in this research work should thus
contribute to our understanding of the responsibilities of bank regulators and the
consequences of excessive regulatory actions and therefore, support more
effective banking regulation. (Vittas, 1992)
d. Policy Makers: Financial markets and institutions are central to economic
development and growth. Increasingly, scholars acknowledge that a supportive
policy for financial sector development is a key component of national
development policy. The responsibilities of these policy makers can be positively
enhanced if they understand what really drives competition in the banking
industry especially for developing countries like Nigeria, which this research work
aims to espouse. A comparative analysis of the growth rates of different countries
has produced convincing evidence that having a deeper financial system
contributes to economic growth and that knowledge is not merely reflected in the
wealth and prosperity of a nation (Honohan and Beck, 2007). Moreover, the
development of the financial sector which can be driven by the competitive nature
of the commercial banking industry is fundamental to the conduct of monetary
policy. Countries with deep financial systems also seem to have a lower incidence
of poverty than others with the same level of national income.
A detailed analysis of the economic role of bank competition which has been
highlighted in this research work should also contribute to our understanding of
the responsibilities of policy makers and the consequences of recommending
stringent policies actions and therefore, support more effective policy making
(Vittas, 1992). Policymakers will typically recommend measures aimed at fueling
competition, promoting the liberalization of financial markets and removing
barriers to entry (Vittas, 1992) as recommended in this research work.
e. Bank Customers: For starters, bank customers can now hold their own against
the might of the banking industry. The democratization of information and
communication has turned the average banking customer into an aware and
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28
confident individual who is not shy of voicing an opinion in public, this is one of
the positives of commercial banks adopting competitive measures. This evolution
has brought about greater diversity in consumer need, along with the expectation
of fulfillment since banks profitability has been matched to total customer
deposits and returned a positive correlation as highlighted in this research
work. Hence, every customer demands that his bank pay close attention to his
unique requirements and customize its products, services and experience to his
liking. Under severe competitive threat, the banks have no choice but to comply,
else it risks losing business to a rival that will.
Fortunately, the emergence of online technology, self-service mechanisms and
social media has made it feasible for banks to gather customer information in
granular detail and use that insight to restructure a defined basket of offerings into
an almost unlimited set of personalized variants. It goes without saying that a
flexible, agile and integrated core banking platform is absolutely necessary for
realizing this goal. This is why bank customers should know the impact of
competition on the profitability of their banks and hence their behaviors. Also,
since customer expectations are not just confined to products, but extend to prices
and delivery as well, which are important ingredients in their profitability
assessment; there is a need to take appropriate action on that front. The pricing
perspective implies that each competing bank must set fair and transparent prices
and they can attract customers and boost their profitability with good
deals. What’s more, the rising popularity of banking institutions to connect with
their customers at many several touch points is only a testimony that the
competitive battleground just got bigger!
f. Research Analysts: Commercial banking profitability studies highlighted in this
research work apply the structure-conduct performance (SCP) hypothesis to the
banking industry. According to the hypothesis, the degree of competition among
firms in a banking market is influenced by the degree of concentration of their
output (loans, assets and deposits) among a few relatively large banks, since a
more highly concentrated market structure is assumed to be conducive for more
effective collusion and hence enhanced profitability among the commercial banks
(Smirlock, Gilligan and Marshall, 1984; Molyneux, Lloyd-Williams and
Thornton, 1994; Mugume, 2010). However, a conflicting version of the Efficiency
Structure Hypothesis (ESH) postulates that an increase in banks’ profitability is
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29
majorly attributable to the total efficiency improvement in its operations. In this
research work, this hypothesis will be tested by estimating measures for bank
performance (profitability) as a function of concentration and efficiency in the
local market. If the market share paradigm of the SCP reveals positive and more
substantial empirical support, authorities will be advised to put more emphasis on
promoting competition in the banking industry, regulating banking product prices
in the industry and generally discouraging further mergers of banks.
However, if the ESH theory which asserts that only efficient firms can attain an
increase in market share and hence their profitability because of their superiority
in producing and marketing products then authorities will be expected to put more
emphasis on promoting competition in the banking industry and discouraging
further banking consolidation reforms (Demsetz, 1973). Therefore, a resolution of
these conflicting theories, as attempted in this research work is a veritable ground
for further research analysis especially for developing countries in Africa.
1.8 Limitations of the Study
Conducting a research project of this nature may not be totally complete without
stating some obvious limitations. The major limitation in this research is the use of
secondary data which may inherently contain errors that can affect the validity of our
own research findings, recommendations and suggestions. This limitation is
highlighted here for obvious reasons.
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CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.1 Introduction
In recent years we have witnessed a substantial convergence of research interest and
the opening of a debate on the economic role of market competition in the banking
industry. The need for such a debate may seem unjustified at first but common
wisdom will hold that restraining competitive market forces from interacting will
unequivocally produce welfare losses (Simpasa, 2013). Banks with monopoly power
will exercise their ability to extract rents (installmental interest receipts) by charging
higher loan interest rates to businesses and by paying a lower rate of return to
depositors.
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37
Higher lending rates will distort entrepreneurial incentives toward the undertaking of
excessively risky projects, thus weakening the stability of credit markets and
increasing the likelihood of systemic failures. Higher lending rates could also limit
firms’ investments in research and development, thus slowing down the pace of
technological innovation and productivity growth. On the other hand, a lower supply
of loanable funds, which is often associated with higher lending rates, should also be
reflected in a slower process of capital accumulation and therefore, in a lack of
convergence to the highest levels of income per capita (Simpasa, 2013). These are
some of the conventional effects that market share in the banking industry is
commonly known to generate.
However, in more recent years, researchers have begun analyzing additional issues in
the matter of bank competition, highlighting potentially negative aspects and so
raising doubts regarding the overall beneficial welfare impact of bank competition on
the economy. The research efforts devoted to this issue has increased tremendously
within the last decade, a sign that the time is ripe for an open debate regarding the
costs and benefits of bank competition. A key assumption in much of the literature
used in this research work is that banks are generally in this business to maximize
profits.
It is in fact one of the (few) assumptions that is shared by almost all the models that
were reviewed for the purpose of completing this work. At this point in our
discussion of the impact of competition in the profitability of commercial banks in
Nigeria, it is instructive to remind ourselves of exactly why banks should maximize
their profits. To be sure, standard theory tells us that a bank’s shareholders are the
principal claimants to its profits and it is therefore in their interest to maximize these
profits. Commercial banks will maximize their returns on investment by maximizing
their revenues and by minimizing costs (Berger and Hannan, 1998). Banks are a
service industry. They contribute to the economic growth of the country not by
producing real goods, but by providing the financial means to facilitate the production
of goods in other industries (Allen and Gale, 2004a).
Therefore, an efficient banking sector should make one of the largest contributions to
the nation’s economic growth. As in other industries, the degree of competition in the
banking industry can matter for the efficiency in the provision of financial services,
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38
the quality of financial products, and the degree of innovation in the banking sector.
Specific to the financial sector is the link between competition and profitability, long
recognized in theoretical and empirical research and most importantly, in the actual
conduct of prudential policies towards banks (Vivex, 2001; Classens and Laeven,
2004; Berger and Hannan, 1989; Allen and Gale, 2004b). The impact of competition
in the banking system should be measured with respect to the actual behavior of
commercial banks in relationship to their profitability. There are three broad issues
related to studying the impact of competition on the performance of commercial
banks. These according to Bikker and Haaf, (2001) are:
1. Do we need a competition policy to be formally put in place as a strategy
document to guide the operations of commercial banking in Nigeria? If we do,
2. What might be the possible coverage of the competition strategy policy?
3. How will such a policy relate to the broader economic objective of enhancing
commercial banking profitability?
In this literature review, we intend to review the relevant literature that will enable us
answer all the questions and more under 2 major headings: theoretical review of
relevant literature and the empirical review which will highlight some of the recorded
statistics, that are attributable to assessing the impact of competition on the
profitability of commercial banks in Nigeria.
2.2 Theoretical Review of related Literature
The impact of changes in bank performances (profitability) has been the focus of
considerable scholarly effort during the past decade. Most of the studies have taken a
cross section of different banking markets, applied a multiple regression technique to
their performances (profitability) just to isolate the effect of changes in market share
on bank performance and then used the resultant coefficient of the H statistic to
determine the impact of competition in a given market as was postulated in the market
structure model of Panzar and Rosse (1982). The H statistic as adopted in this
research work therefore, is the coefficient of the proxies of competition, such as
market share, efficiency and concentration on the profitability of banking
performances analyzed using a multiple regression technique. In general, the results
of previous researchers indicate that changes in market share affect both the pricing of
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banking products and the quality of banking services provided to customers, but that
their impact on banking profitability is quite small. However, there are so many other
contradictory results that have also been obtained in similar studies.
Our present jet age and the resulting euphoria in the market place have placed the
ultimate weapon of conviction in the hands of the marketers of banking products and
services hence driving banking competition and ultimately efficiency. Banking
efficiency is instrumental to economic development (Barajas, et al., 2000).
Inefficiencies in the financial systems of most developing countries have persisted
even though many of these countries have undertaken financial reforms over the past
two decades or so. Gilbert (1984) observe that in many Sub-Saharan Africa (SSA)
countries the range of financial products remain extremely limited, interest rate
spreads are wide, capital adequacy ratios are often insufficient, loan recovery is a
problem and the share of non-performing loans is large. The expectation is that
removing government controls on interest rates and lifting barriers to entry into the
financial system would lead to greater competition and improve performance of the
financial institutions. A number of studies have also argued that unless banks’
behavior changes, the financial reforms that most of the developing countries have
implemented cannot lead to a significant improvement in the efficiency of their
financial systems (Gibson and Tsakalotos, 1994; Barajas, Steiner and Salazar, 2000).
We can deduce several explanations for these limited changes in the financial system
efficiency of these countries following these financial reforms:
First, following Bain’s market structure, conduct and performance (SCP) hypothesis
in the industrial organization which has been widely applied in the banking industry
(Bain, 1951), it postulated that poor banking performance may continue to persist if
financial sector reforms do not significantly alter the structure within which banks
operate. The interpretation here is that, for financial reforms to be effective in most of
these developing countries, including Nigeria, the financial institutions must
significantly alter their market structures to enhance their acquisition of a larger
market share. As a confirmation of the above theory, a recent research by Gibson and
Tsakalotos (1994) have pointed out that the impact of competition resulting from
conditions of free entry and competitive pricing will raise the functional efficiency of
intermediation by decreasing the spread between deposits and lending rates.
Although, the empirical evidence of a positive and significant relationship existing
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between market share and banks’ profitability yields non-robust results, there is
compelling evidence to suggest that market share plays an important role in altering
the performance of commercial banks (Gilbert, 1984; Berger and Hannan, 1989;
Molyneux and Forbes, 1995; Demirguc-Kunt and Huizinga, 1999). The most recent
literature on the impact of banking reforms and financial liberalization on profitability
by Barajas et al., (1999, 2000) also supports the hypothesis that commercial banks’
profitability indicators are positively related to market share.
Secondly, the removal of credit controls during financial reforms which may worsen
the quality of loans, may in turn lead to increased risks of systemic crises and
decrease commercial banking profitability arising from changes in the financial
system efficiency of countries following financial reforms:. Brownbridge and
Kirkpatrick (2000) note that liberalization of interest rates and removal of credit
controls as measures of banking reforms may allow commercial banks that are not
constrained by prudential regulations to begin to invest in risky assets in order to
maintain larger market shares and hence enhance their profitability indicators. This
may reduce the quality of loans and may result in a higher proportion of non-
performing loans and provisions for doubtful debts. Banks tend to offset the cost of
screening and monitoring attributable to bad loans or the cost of forgone interest
revenue by charging higher lending rates (Barajas and Salazar, 1999; 2000). These
responses as a result of banking reforms are most likely to affect the banking sector’s
profitability.
The works of Barajas and Salazar (1999, 2000) also found support for the positive and
significant relationship existing between poor bank performances (Lower
profitability) and provisions for doubtful debts in some Caribbean countries. They
further confirm that the cost of poor quality loans is usually shifted to bank customers
through higher spreads in the Caribbean countries e.g. Colombia. Their works also
found a significant and negative relationship existing between poor bank performance
and provisions for doubtful debts in other Caribbean countries such as Argentina and
Peru. (Barajas and Salazar, 1999; 2000). These are evidences from countries that have
recently implemented financial reforms in their systems.
Thirdly, there is overwhelming theoretical evidence that high non-financial costs
resulting from banking reforms are also a source of persistent inefficiency in the
banking sector in developing countries such as Nigeria. Non-financial costs reflect
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variations in physical capital costs, employment and wage levels. High non-financial
costs may result from inefficiency in bank operations that may also be shifted to bank
customers, particularly in imperfect markets, thereby impacting on the profitability of
commercial banks. Dermirguc-Kunt and Huizinga (1999) in their analysis found
evidence of a negative relationship existing between banks profitability and overhead
costs – operational expenses for firms in industries that have recently implemented
financial reforms. This relationship was also confirmed by Barajas and Salazar in
their works (Barajas and Salazar, 1999; 2000) when they reported a significant and
positive relationship existing between banking inefficiency and non-financial costs
even for countries that have recently implemented financial reforms.
Fourthly, macroeconomic instability and the policy environment may also affect the
pricing behavior of commercial banks after banking reforms and therefore impact on
their profitability. In order to capture the effects of the macroeconomic and policy
environment, the banks’ profitability equations must include inflation, growth of
output market, growth of the money market, real interest rates as control variables.
For example, Claessens et al. (2001), Dermirguc-Kunt and Huizinga (1999), and
Brock and Rojas-Suarez (2000) note that banking industry performance and inflation
are negatively associated. In Nigeria, ambitious financial reforms were initiated in the
economy specifically between 2004 and 2007 that were aimed at: (Nannyonjo, 2012)
Redefining the structure and operations of the financial institutions
Easing of entry requirements for foreign banks
Limiting mandatory investments
Reducing the reserve requirement ratio
Phasing out direct monetary policies
Privatizing the state-owned financial institutions and
Strengthening prudential norms.
In particular, a weak financial industry limits the efficient aggregation and allocation
of resources and subsequently causes wastes in those sectors and enterprises that are
less well linked into the financial pipelines. Moreover, the recent reforms,
(Nannyonjo, 2012) particularly within the banking system, may have resulted in a
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sound, competitive and efficient system that can deliver on greater access and
financial deepening with an overall increase in the sector’s profitability. Nigeria’s
banking industry is undergoing unprecedented changes, caused by the deregulation of
financial services, strengthening of regulatory and supervisory frameworks and
developments in information technology. An integral part of the process has been the
liberalization of international capital movements. Many of these changes could have
had vast implications for competition and concentration in the banking and financial
sectors. The combination of improvements and unfulfilled potential warrants this new
look at Nigeria’s banking sector. One of the advantages has been mergers and buyouts
which has increased concentration.
In summary, whilst financial reforms should generally lead to improved banking
sector performance, whether actual improvement really occurs will depend on a
number of other exogenous factors such as the pricing of bank product, the behavior
of customers, banking regulations, etc. Generally, banks’ efficiency can increase or
remain low depending on the competitiveness of the banking system, the cost
structure of the market, the sophistication of the banking system and the
macroeconomic environment. According to the literature on industrial organization,
(which has been severally applied in the banking industry) as was postulated by Bain
(1951) there are two main explanations for the likely impact of market share on the
conduct and performance of firms. These are market share and efficiency.
The market power theory has two hypotheses: the structure-conduct performance
(SCP) hypothesis and the Relative Market Power (RMP) hypothesis. The traditional
structure-conduct-performance hypothesis is based on the proposition that the
persistence of financial profits is indicative of distortions in allocating resources in the
economy which are due to some features of market structure that foster collusion and
retard competition among firms in the industry (Bain, 1951). Since concentration
facilitates collusive or monopolistic practices, firms in concentrated markets will earn
higher profits than firms operating in less concentrated markets irrespective of their
efficiency. This hypothesis suggests that banks in concentrated markets would be able
to extract monopolistic rents (periodic receipts of interest income) by their ability to
offer lower deposit rates and higher loan rates (Bain, 1951). For its part, the relative
market power hypothesis (RMP) states that only firms with large market shares and
well-differentiated products are able to exercise market power in pricing their
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products and earning supernormal profits (Shepherd, 1986). A number of studies have
either applied the Bresnahan methodology or the Panzar and Rosse methodology to
the issue of competition in the financial services sector, specifically in the banking
industry.
For example, Shaffer (1989) used the Bresnahan model to study the impact of
competition on a sample of US banks and found results that strongly reject collusive
conduct among competing banks but noted that banks whose conduct were consistent
with perfect competitive behaviors had significant and positive relationship between
competition and profitability. Again using the same Bresnahan model, Shaffer (1993)
found that the Canadian banking system was also competitive over the period 1965 –
1989, although, their banks were relatively concentrated. Also, Shaffer (2001) used
the same Bresnahan model to study the impact of competition on the profitability of
banks for 15 countries in North America, Europe, and Asia during 1979 – 1991 period
and found a significant and positive relationship existing between the market share
and profitability in 5 markets and excess capacity in only 1 market. These findings are
consistent with the findings of Shaffer (1982) when he applied the Panzar and Rosse
methodology (P–R multiple regression model) to a sample of New York banks using
bank panel data for 1979 and found that monopolistic competition existed in New
York banks.
However, Nathan and Neave (1989) who also studied a sample of Canadian banks
using the P-R methodology found results inconsistent with the results of Shaffer
(1989) using the Bresnahan methodology, i.e., a rejection of monopoly power in
banking markets which connotes collusive behaviors. Several other authors have
applied the P-R multiple regression methodology to European banking system
(Molyneux et al., 1994; De Bandt and Davis, 2000) and obtained results similar to the
ones of Shaffer (1989) and Nathan and Neave (1989). Generally, these studies reject
both perfect collusion and perfect competition as having significant impact on the
profitability of banks but find significant and positive evidence of monopolistic
competition. Tests on the competitiveness of banking systems for developing
countries such as Nigeria and other transition economies using the Bresnahan and
Panzar – Rosse models are few to date as compared to tests using the P-R
methodology in developed countries.
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2.2.1 Market Share Models:
In distinguishing the types of competition that firms can engage in, the Panzar-Rosse
multiple regression model was adopted in the research works of Bikker and
Groeneveld (2000) and Bikker and Haaf (2002) to determine a dependency of mar