Equilibrium and competition in the banking sector - Literature review Example

?Topic: Equilibrium and competition in the banking sector LITERATURE REVIEW Introduction Equilibrium and competition in the banking sector has been analysed through various general equilibrium banking models along with the role of mediation technology. Banking competition plays a critical part in the equilibrium level in various monopolistic, perfect and conditions of imperfect competition, as depending on the mediation technologies. Literature speaks of limited equilibrium modelling. General equilibrium, according to researchers depends on various market conditions. Further, level of equilibrium in banking industry depends on competition and financial stability, which depends further on banks’ risk-taking initiatives. Literature review discusses the opinions of various authors on the banking products as trade off between competition and financial stability on different risk choices. Various risk-transferring models are discussed. Role played by bank supervising technologies forms part of various models. New models of bank risk-taking, named partial equilibrium models are analysed. The UK banking sector is statistically reviewed through the Panzar and Rosse model. Literature review attempts various views on banking competition and financial weaknesses through various models to know if any relationship between equilibrium and competition can be established or not. Past Research As stated by Allen and Gale (2004a), the relationship between banking competition and financial health has been majorly discussed in the discourse of limited equilibrium modelling. There are not many general equilibrium models in literature. Allen and Gale (2004b) discuss a general equilibrium type of a Diamond and Dybvig (1983))-type economy and show that perfect competition among mediators is Pareto optimal under complete markets, and limited Pareto optimal under incomplete markets, with economic ”instability” as an agreed stipulation of optimality. Similar outcomes are derived when there is reduced inflation in the general equilibrium monetary economy with aggregate liquidity risk studied by Boyd, De Nicolo and Smith (2004)). Nevertheless, these general equilibrium models do not portray ethical risks because of unnoticed risk alternatives of banks and banking firms, as academics perceive. Banking sector can be stated in partial equilibrium if the exchange between competition and financial stability is generally achieved via a standard risk transferring statement practiced on a bank that arranges funds from insured customers and selects the risk of its investment. In such a scenario where market indicates limited liability, sudden risk alternatives, risk-free deposit demand, and stable return to scale in checking, a high in deposit market competition heightens the deposit rate, decreases banks’ anticipated margins and inspires banks to take advances in risk-taking. This conclusion has been derived by Allen and Gale (2000) in both fixed and ordinarily changing scenarios. A number of scholars in literature have supported this predictability in their works, including Keeley (1990), Matutes and Vives (1996), Hellmann, Murdock and Stiglitz (2000), Cordella and Levi-Yeyati (2002), Repullo (2004) among many others. Nevertheless, in the case of competition among banks in loan and deposit markets, it is loan rate that governs the degree of risk-transfer initiated by companies, as stated by Stiglitz and Weiss (1981). Boyd and De Nicolo (2005) discussed the evaporating trade-off between competition and financial stability when various risk alternatives are analysed by firms. A rise in loan market competition cuts down bank loan rates, strengthening firms’ anticipated profits and prompting them to select secure investments, which gets written into securer bank loan portfolios. Amidst this increasingly conflicted environment, the risk-transferring statement is used on two market units, firms and banks, in stead of a single entity. Latest versions of this kind of model, including bank heterogeneity (De Nicolo and Loukoianova, 2007), the initiation of various assets (Boyd, De Nicolo and Jalal, 2009), or a distinct risk mechanism (Martinez-Miera and Repullo, 2010), have all targeted towards the setting of conditions of two risk-transferring impacts creating a bargain between bank competition and financial stability. Common thing about all these researches is the presence of bank supervising technologies indicating fixed return to scale and that the bank risk is not finalized collectively by banks and borrowers. The first assumption of fixed returns to scale differs with the literature research by Diamond (1984)), Boyd and Prescott (1986)), Willliamson (1986)), Krasa and Villamil (1992)) and Cerasi and Daltung (2000)) who all have found economies of scale in supervision as a must trait of mediation. This has inspired study of these models under fixed and increasing returns to scale in the mediation technology. Besides, these models do not differentiate between banks’ and borrowers’ functions to take the final decision on risk transfer by the bank or by the borrower straight-way while banks select risk only indirectly via the fixing of loan rates. It has been proved in past literature that connection between competition and financial fragility is quite complicated and multi-sided (see Allen and Gale, 2004a). Actually, there is no unanimity over the type of this relationship or over the derived meanings of banking competition. The literature supports many controversies in favour and opposition of supporting banking competition, which is quite perplexing because these two issues are handled at the same time by stakeholders. Literature has focussed on three leading trends with the relevant theories along with statistical research on them (Ruiz, 2008). The first perspective states that competition promotes fragility. Statistically, as per this argument, fragility appears because of agency issues between banks, customers and deposit insurance finances or for non-focussed banking systems (see Keeley, 1990 and Beck, Demirguc-Kunt and Levine, 2003). From theoretical point of view, it is backed by studies that stress on the risks attached to competition for deposits, banking deregulation and risk taking practices of banks (see Matutes and Vives, 1996, Repullo, 2004 and Dam and Zendejas-Castillo, 2006). This has been a leading view in the literature. The primary meaning taken from view is that banking concentration could increase banking stability. Such derivations state why the need for banking competition has since long time been inquired into. Nevertheless, this deduction is questionable. For instance, some researches indicate that banking concentration is positively correlated to competition (see Claessens and Laeven, 2004). Moreover, other research state that the problem of competition negatively affecting the stability of banking systems is not fully comprehended (see Carletti, 2007). The second point-of-view states that banking competition encourages financial stability. Similar to the past view, it is also based on a number of research works. This view has been advocated statistically by analysing the history of US banks and research work that stresses on global cross-sectional data (see Rolnick and Weber, 1983, and Claessens and Klingebiel, 2001, respectively). Theoretically, this point-of-view is backed by studies that favour the notion that competition may encourage stability by cutting down information irregularities or by encouraging liquidity arrangements via inter bank markets (see Caminal and Matutes, 2002 and Bossone, 2001, among others), thus supporting free banking. Dowd (1996) ardently speaks in favour of this notion on three counts: 1) if laissez-faire is good, there must be a prominent appeal in favour of it in banking; 2) if laissez-faire looks out of tradition at first view, this is because we make assumptions (like government intervention in the financial sector); 3) empirical evidence is consistent with free banking theory. Such arguments are supported by those who claim that banking failures are the indirect result of regulatory efforts (see Benston and Kaufman, 1996). Coming to the third perspective, it guides that the studied relationship is not just an ordinary bargain; it is beyond that. Allen and Gale (2004a) analyse the effective degree of competition and stability with a number of models. The basis of the origin of their research is general equilibrium models of intermediaries and markets, agency models, models of spatial and Schumpeterian competition and models of contagion. Trade off is not available in all models but some models. This aspect could state the complex outcomes noticed by scholars. Various outcomes can be seen because of the outcome over the assumptions, situations and information employed to study competition. The third perspective also indicates that the outcome on competition may count on particular economic situations. Particularly Boyd, De Nicolo and Smith (2004), exhibit that a monopolistic banking structure has more probability of increased failure relatively to a competitive one, when the inflation rate is below a particular degree; otherwise, the contrary derivation applies. Moreover, Boyd and De Nicolo (2005)) have exhibited that the outcomes of banking competition reckon on reverse risk motivating mechanisms. One is related with the selection of riskier portfolios when competition heightens. The other is related with the heightening of default risks when banking markets become more contracted. The three perspectives stated above do not outwardly assume the financial climate wherein banking functions are performed. Nevertheless, the possibility for financial brokers to manage financial risks and to involve in risk dissemination functions depends on the specific traits of the financial systems (See Allen and Gale, 2000 and 2004b). The analysis of the relationship between banking competition and financial weakness can be associated with the theory on comparative financial systems for such traits depend on financial competition; particularly they depend on the competition between banks and markets and among banks themselves. Ruiz-Porras (2008) figure out that financial system pointers need to be a part of the statistical research on the association between banking competition and financial weakness. Adhering to methods, their inclusion will help in locating the traits of financial systems. Presently, selected researches associate financial and weakness indicators (see Ruiz-Porras, 2006 and Loayza and Ranciere, 2006). Nonetheless, these researches are not related to banking failure-deciding studies. Ruiz-Porras justify this thought of including financial indicators as governing variables in measurements in the context of the relationship between competition and weakness. It is derived from the above analysis by exhibiting that the discussion is inconclusive with regard to the outcomes of banking competition on financial weakness. The literature is insufficient and inconclusive (see Carletti, 2007). Prevailing research indicates that these outcomes may not be unambiguous or direct. Therefore, more research is required for policy aims. Ruiz-Porras, especially, consider that statistical researches based on the theory of comparative financial systems may help in stating the discussed relationship. Actually, this theory and the need to conduct more research inspires and distinct the research of Ruiz-Porras, guiding some of its methodologies (Ruiz-Porras, 2008). These days, as banks practice relationship and commercial lending to attain industry-particular acumen and maintain relationships with singular firms, it can offer the insight and leverage to banks through their access on the information. Banks offer credit by considering not only the present worth of a firm’s start-up project but on its future revenue-earning capacity. Both types of lending strengthen banks’ power, which according to Peterson and Rajan (1995), banks use in relationship lending by offering credit to new firms at reduced cost, which is different from the traditional competitive route. Banks manage the market competition by charging higher interest rates. It attracts borrowers to start riskier enterprises. Those banks holding market power divide the predictable margins of such firms to get the reward against increased risk-taking by banks in lending rather than heightening the interest rates. As a successful company is not carried and swept away amidst competition, the bank will get the leverage from strengthening the lending relationship for future as well. Banks, as an outcome, will be always ready to offer credit at reduced rate to continue the lending relationship. It shows the significance of banks’ market power. Boot and Thakor (2000) have analysed the negative connection between competition and relationship lending, common in the theoretical parlance by providing a model wherein banks can involve in both relationship and transactional lending. They speak positively on the heightened relationship lending amidst competitive climate by giving the example of a monopoly bank that offers both categories of loans. Since criticality of relationship loans is higher for low and medium category borrowers, the monopoly bank gets some or all the value leveraged. On the contrary, top-rated borrowers do not depend on relationship for their borrowing needs and banks are also east interested in putting their investments in big accounts as offering reduced value to banks. Such high profile borrowers are offered transactional loans. As the competition heightens, surplus with banks reduces from relationship loans. It inspires banks to reduce their investment in such lending, relevant with Petersen and Rajan. Nevertheless, Boot and Thakur (2000) indicate that competition will reduce the bank’s margins in transactional lending higher than it would in relationship-lending. This inspires the bank to change over towards relationship lending. Cetorelli and Peretto (2000) have produced a general-equilibrium model of capital addition to test the optimal competitive framework with the aim of reducing information variance via screening. Banks have an interest in checking borrowers to categorise the various kinds of borrowers but screening is expensive and can be effective only in a limited way as competitor banks can see through the outcomes of the screening process. Banks are hesitant in screening also because of the free rider attached that reduces a bank’s motivation to screen. Cetorelli and Peretto indicate that to control the free-rider issue, the safe strategy for banks is to screen only a selected number of borrower and distribute lending between both, “safe” and “risky” borrowers. There is a negative outcome from the relationship between the number of banks and their impression on growth. With the reduction in the number of banks, amount of credit available with the banks also reduces but it motivates banks to screen borrowers and with that heightens the proportion of “safe” top-rated loans. With the reduction in the number of banks, the outcome is realised in the happening of a trade-off between the amount of credit offered and the kind of borrowers, which is accrued through effective capital distribution by the banks. This trade-off is critical for economic development. Cetorelli and Peretto indicate that this state helps an oligopoly framework, not a perfectly competitive market design in achieving optimum level of growth. Empirical results The theories provide contrasting meaning for credit and development. As per the conservative IO structure, market power transforms to increased loan rates and reduced credit provision, which creates negative impact on growth. In the second kind of theories, market power can help in bettering the information creation activity of banks via relationship lending and screening, which betters the effective distribution of funds. In examining these theories, the statistical literature majorly employs the strength of banks or the level of concentration in the banking area as a proxy for market power. The most of the past literature employs U.S. data to test the relationship between bank margin earning capacity (or prices) and concentration. For instance, Berger and Hannan (1989) exhibit that concentration is related to lessened deposit rates and Hannan (1991)) concludes that an increase in concentration is linked to heightened loan rates. Actually, past research randomly sees a positive relationship between concentration and margins, which strengthens the saying that market power is critical. A leading issue with a number of these researches is that they do not consider variations in production efficiencies. A very effective bank may accrue increased margins because it excels in optimising values. Its achievement can heighten concentration, as it could naturally posses a bigger chunk of the market and manipulate its success as a pedestal from which to acquire less efficient banks. Concentration could as a result be linked to increased bank margins, without essentially undergoing the negative effect on credit availability forecasted by the market power theories. Later writers have strived to attend to this problem. For instance, after managing for variations in performance, Berger (1995) presents mixed outcomes. Although he notes that market share is positively tuned to profitability when performance is attained, concentration in the banking market is generally negatively tuned to profit. A matching research on the European banking industry by Punt and Van Rooij (2001) also has varied outcomes. Although they notice some back up for a positive relationship between concentration and margin earning capacity, their outcomes are not strong enough to various specifications of margin ability. Petersen and Rajan (1995) employ U.S. data to examine their relationship-lending theory. Employing concentration as a mark of market power, they notice that budding firms get more credit in concentrated markets than do matching firms in less-congested banking markets; they also notice that creditors in congested markets seem to level interest rates over the life term of the firm, asking reduced rates when the firm is budding and increased rates when the firm is old. Latest research employs panel data to test the impact of concentration within the wider financial mechanism. Cetorelli and Gambera (2001) employ a cross-country, cross-sector dataset to examine the average impact of bank congestion on development in various sectors. They note that congestion has a comprehensive negative impact on development but that the impact is heterogeneous over firms. Industries where budding firms are more dependent on outside liquidity, money increases quicker there as banking industry is more congested (which backs the notion of relationship lending). Corvoisier and Gropp (2002) employ a European dataset to analyse the relationship between congestion and loan costing while managing for competitive situations, cost frames and risk. Taking note of the fact that various banking products may be affected variously by banking congestion, they generate different congestion and cost measures for each of four products: loan, demand, savings and term deposits. They note that heightened congestion is linked to reduced competitive costs in the loan and demand deposit markets but not for the other products. Thus, various product markets may be affected variously by congestion. Beck, Demirguc-Kunt, and Maksimovic (2003) employ a dataset of developed and developing countries to verify the impact of congestion on credit availability while managing for regulatory policies like arrival, ownership framework and limitations on bank functions. They note that firms are presented with increased financing hurdles in congested banking markets. The negative impact, nevertheless, is reduced by effective legal processes, reduced degree of corruption, increased degree of financial and economic growth and the entrance of foreign banks. Actually, the impact is not critical for countries that have a well-grown financial system. Lastly, Demirguc-Kunt, Laeven, and Levine (2003) verify the impact of congestion and different regulatory policies impacting competition on net interest profits. The regulatory policies include entry limitations, limitations on the functions that banks can deliver and reservations on opening a bank. Each of these is noted to heighten net interest profits. Bank congestion is also linked to increased profits but the impacts become unimportant once governing policies and routine climate factors are managed for. The statistical literature that connects banking congestion to increased margins is not understandable. Past researches do note that banking congestion is positively linked to margins but the outcomes are not strong enough over time, products or counting of margins. Also, latest literature indicates that managing for factors like variations in performances over banks and variances in the competitive climate like entry restrictions can reduce and even erase the positive relationship between banking congestion and margins. Nicolo and Lucchetta (2011) have researched the versions of a general equilibrium banking model with ethical risk under the two situations of constant and increasing returns to height of the mediation technology employed by banks to check and supervise borrowers. If the mediation technology indicates increasing returns to the desired level or it is comparatively effective, then perfect competition is optimum and guides to the minimum possible degree of bank risk. On the opposite side, if the mediation technology indicates constant returns to the scale, or is comparatively ineffective, then imperfect competition and mediation degrees of bank risks are optimal. These outcomes are statistically pertinent and have critical meanings for financial policy. Nicolo and Lucchetta (2011) have gone a step further from the previous models by stating that bank risk is collectively undertaken by the bank and the borrower, as presented in their extended model. Moreover, as stated by Gale (2010)), most partial equilibrium models take it for granted that the supply of bank capital is totally flexible at a given outgoing rate and provide different outcomes over the connection between capital and bank stamina to take risk. Nicolo and Lucchetta have extended their past study conducted in 2009 to introduce bank and firm capital in easy way to count bank and firm rewards to select the unit of investment of internally created capital collectively with their risk-taking judgements. Another important aspect of partial equilibrium models has been, as analysed above, the presence of deposit insurance. This condition is applicable on the standard risk-transferring statement to apply but as equilibrium or multiple equilibriums do not exist in the case of balanced pricing of deposit insurance and there is no logic of deposit insurance in risk-free world, deposit insurance can not be taken to exist (Nicolo and Lucchetta, 2011). Maimone (2012) has studied the UK banking sector to be comparatively more competitive and seems therefore to be financially more robust. It is stated that there is lack of required level of competition and new banking organisations can not enter the market. A research by Matthews, Murinde and Zhao (2007)) inquires the level of competition in the UK banking system between 1980 and 2004 using the Panzar and Rosse (1982, 1987)) methodology. As per the model if the market is competitive, new players can enter and leave the market at their will even if the market is in he hands of selected players to fix the prices equal to marginal costs by using the technique of getting verifiable limitations upon the firms abridged form revenue equation. The research methodology of Maimone (2012) is based on statistics taken from the index (the Panzar-Rosse H-statistic) of the amount of the elasticity of income to factor values. If it is between 0 and 1, competition will be monopolistic or part equilibrium, while on the other side H < 0 would mean a monopoly and H = 1 would translate to perfect competition. The major lead is that if the market is featured by perfect competition, a hike in input costs won’t impact the turnout of firms, which will not happen under monopolistic competition. Maimone (2012) conducted an analysis of Mathews et al. (2007)) model equilibrium test outcomes, stating that the null hypothesis that the bank’s fixed impacts are together zero (H0 : hi = 0) is cancelled at the 1% criticality degree for the full sample and for the second sub-sample but it does not apply on other sub-samples. In totality, it shows the relevancy of the fixed impacts panel model that permits for bank heterogeneity. The primary attraction in the model is the equilibrium test. The analysis shows a little proof of disequilibrium for the complete sample but not for the various sub-samples. Their analysis shows the market to be nicely placed in the position of equilibrium and further research can be conducted to find the degree of competition through the Panzar-Rosse (PR) methodology (Maimone, 2012). References: Allen, F., & Gale, D., 2000. Comparing financial systems. MIT Press, Cambridge, Massachusetts. Allen, F. & Gale, D., 2004a, Competition and financial stability. Journal of Money, Credit and Banking, 36 (2), 453-80. Beck, T., Demirguc-Kunt, A. & Maksimovic, V., 2003. Bank competition, financing obstacles and access to credit. World Bank Policy Research Working Paper No. 3041. Berger, A., & Hannan, T., 1989. The price-concentration relationship in banking. Review of Economics and Statistics,71, 291–99. Berger, A., 1995. The profit-structure relationship in banking—tests of market power and efficient-structure hypothesis. Journal of Money, Credit, and Banking, 27, 404-31. Boot, A.W.A., & Thakor, A.V., 2000. Can relationship banking survive competition? Journal of Finance, 40 (2), 679–713. Boyd, John H. & De Nicolo, G., 2003. Bank risk taking and competition revisited. IMF Working Paper 03/114, International Monetary Fund, Washington D.C. Boyd, John H., De Nicolo, G. & Smith, B. D., 2004. Crises in competitive versus monopolistic banking systems. Journal of Money Credit and Banking, 36 (3), 487-506. Boyd, J. H., De Nicolo, G. & Jalal, A. M., 2009. Bank competition, risk, and asset allocations. IMF Working Paper 09/143, International Monetary Fund, Washington D.C. Cetorelli, N., & Peretto, P., 2000. Oligopoly banking and capital accumulation. Federal Reserve Bank of Chicago Working Paper No. 12. Cetorelli, N., & Gambera, M., 2001. Banking market structure, financial dependence and growth: international evidence from industry data. The Journal of Finance, 56 (2), 617–48. Corvoisier, S., & Gropp, R., 2001. Contestability, technology and banking. Paper presented at the EFA 2002 Berlin Meetings. Available from: http://ssrn.com/abstract=299404. Demirguc-Kunt, A., Laeven, L. & Levine, R., 2003. The impact of bank regulations, concentration, and institutions on bank margins. World Bank Policy Research Working Paper No. 3030. De Nicolo, G. & Loukoianova, E., 2007. Bank ownership, market structure and risk. IMF Working Paper, 07/215, International Monetary Fund, Washington D.C. De Nicolo, G. & Lucchetta, M., 2011. Bank competition and financial stability: a general equilibrium exposition. IMF Working Paper/11/295. Available from: http://www.imf.org/external/pubs/ft/wp/2011/wp11295.pdf Petersen, M. & Rajan, R.G., 1995. The effect of credit market competition on lending relationships. The Quarterly Journal of Economics, 110, 407–43. Punt, L.W., & Van Rooij, M.C.J., 2001. The profit-structure relationship and mergers in the european banking industry: an empirical assessment. De Nederlandsche Bank Staff Reports No. 58. Ruiz-Porras, A., 2008. Banking competition and financial Fragility: evidence from panel-data. Estudios Economicos, 23, (1), 49-87. Available from: http://www.jstor.org Stiglitz, Joseph E. & Weiss, A., 1981. Credit rationing in markets with imperfect information. American Economic Review, 71 (3), 393-410. Read More