Industrial Structure of Banking - Essay Example

School: INDUSTRIAL STRUCTURE OF BANKING Lecturer: Analyse the relationship between market structure and financial development Introduction The market structure of banking can generally be referred to the number of banks concentrated at a particular location (Fama, 2010). This follows the general economic definition of market structure, which puts emphasis on the number of companies engaged in the production of the same products or services which are homogeneous (Glosten and Milgrom, P. (2005). Very often, the banking industry has been noted to be an important stakeholder in financial development. This is a very logical situation to expect, given the fact that the activities of banks are directly involved in the fiscal determinants that brings about financial development. Some of the financial determinants that bring about financial development are the level of improvement with the quality, quantity and efficiency of financial services provided at an intermediary level (Boyd, De Nicolo and Smith, 2004). The discussion as to whether or not degree of cluster or concentration of banks at a given location brings about financial development continues to go on in literature. Very often, the expectation has been that the market structure should influence competition, which in turn should influence the way the banks should engage in the support of local businesses with financial intermediary services, and thus leading to financial development. Some of these arguments in literature are analysed below. Effect of Perfect Competition on Financial Development In a study by Boyd and De Nicolo (2005), they observed that with increases in the concentration of the banking sector, there is an induced internal competition among the banks due to the existence of a perfect competition among the banks. The perfect competition existing means to the banks that there is no barrier to new entrants. This also means that they must guide their strategies along the need to maintaining their customers, while and fighting the threat of new entrants (Fama, 2010). Consequently, Boyd and De Nicolo (2005) noted that with increased banking sector concentration, banks are forced to lower deposit interest rates and rather increase loan interest rates. Once this happens, banks are likely to get more customers opening accounts and thus contributing to the overall internal growth of the banks. On the outside also, borrowers are said to be likelier to be engage in more risky projects as a way of covering up for the high loan interest rates. This way, there is lowering in the overall level of asset portfolio risk (Boyd and De Nicolo, 2005). Using the case of Caribbean banks, Alleyne and Waithe (2009) noticed that the increase in loan interest rates resulting from the banking sector concentration creates a situation whereby such markets with higher interest rates margins record lower ratios of private credit to GDP as showed in the chart below. Fig 1: Net Interest Margin and Private Credit in the Caribbean Source Alleyne and Waithe (2009, p. 29). From the figure, it can be noted that where there is banking sector concentration, there is reduced access to private credit and thus slowing of active economic activity, thereby leading to stagnation in financial development. Meanwhile, the same interest margins which are higher in concentrated banking locations have been found to be useful in financing bank overheads (Moore, 2009). In effect, market structure with concentration of banks leads to better financial performance for the banks in an internal mechanism but not for the later GDP as showed in the diagram above for the case of Caribbean. Effect of Monopolistic Competition on Financial Development There have also been studies, finding the impact of market structure that operates a monopolistic competition. In such market structures, the common practice is that there is an imperfect competition among the banks, such that state-owned banking and other financial institutions have a substantial market share (Maudos and Guevara, 2004). Such market structures have been said to be very common in developing nations. In most of these developing nations and for most of the state-owned banks engaged in the imperfect competition, Alleyne and Waithe (2009) observed likelihood that they will have objectives that are not specifically based on profit or value maximisation. Rather than profit and value maximisation, these state-owned banks sparking the monopolistic competition would concentrate their attention on developing specific industries, sectors, or regions of the economy (Alleyne and Waithe, 2009). Once this situation arises, the other banks in the private sector are forced to respond by introducing products that are differentiated from what the state-owned institutions offer. Consequently, there is lowering of loan interest rates to make the same industries that have been targeted by the state owned banks attractive to the other privately competing banks. As soon as there is such openness in competitive banking, assistance is given to new entrepreneurs and export is boosted, leading to more competition among the beneficiary industry as compared to competition in the banking services (La Porta, Lopez-de-Silanes and Shleifer, 2002). Meanwhile, for most of these developing countries, efficiency with financial development has been said to be largely based on the outcomes of private industries, which in this scenario have been seen to be competing feverishly because of the level of support they get mainly from state-owned institutions. Consequently, the competition among the industries leads to growth, which leads to expansion in the economy and thus better prospective for financial development (Boyd, De Nicolo and Smith, 2004). In effect, monopolistic competition can be found to be more favourable in bringing about financial development. Conclusion From the discussion so far, it has been established that there is a linear or direct relationship between market structure and financial development. However, the outcomes of these relationships are not always the same. Where there is a relatively equal level of banking sector competition, leading to a perfect competition, there is the likelihood that financial development will not be achieved. This is because for most of these markets, the banks lack an internal motivation to concentrate on the growth of industries but rather concentrate on their internal growth. The reason for concentrating on internal growth is due to the concentration of banks, which prompts the lowering of account interest rates and increasing of loan interest rate. But where a giant will arise from among the banks such as state-owned institutions to cause a monopolistic competition, the focus for banking becomes changed and so industries become the point of attention for bank’s activities. Consequently, more support is offered to the industries, prompting massive financial development. References Alleyne A. and Waithe K. (2009). Financial Development and Market Structure. Cave Hill Campus: Barbados. Boyd, J., De Nicolo, G., and Smith, B. (2004). ‘Crises in Competitive versus Monopolistic Banking Systems’, Journal of Money, Credit, and Banking. Vol. 7 No. 2, pp. 23-42 Fama, E. (2010). ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, 25, pp. 383-417. Glosten, L., & Milgrom, P. (2005). ‘Bid, ask and transaction prices in a specialist market with heterogeneously informed traders’, Journal of Financial Economics 14, pp. 71-100. La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2002). ‘Government Ownership of Banks’ Journal of Finance 57 , pp. 265-301. Maudos, J., & Guevara, J. (2004). ‘Factors Explaining the Interest Margin in the Banking Sectors of the European Union’, Journal of Banking and Finance, 28, pp. 2259-2281. Moore, W. (2009). Management Practices and the Performance of Mutual Funds in the Caribbean. University of the West Indies, Cave Hill Campus: Bridgetown. The relationship between market structure and financial stability Introduction Market structure comes in different forms and types, but within the banking sector, the commonest of these that are likely to be found are monopolistic competition and perfect competition. In most locations where there is perfect competition, the prevailing outcome is that there is massive concentration of banks on the market, with each of the banks having a relatively same level of energy to compete (Robinson, 2005). This does not mean however that all banks are the same in strength and market share but each of the banks, no matter how different they may be have their own target groups and so compete very successfully. Such market structures are very common with developed countries. On the other side of the coin where monopolistic competition takes place there is always a super-power bank or set of institutions, mostly state-owned institutions causing an imperfect competition. The activities of such state-owned banks have been to concentrate their efforts on developing industries. Such market structures are common in developing countries. With the understanding that financial stability generally refers to the ability of businesses to meet their debts in due time, researchers have been concerned about how these two market structures affect financial stability (Moore, 2009). Once financial stability is achieved, it is expected that there will be better facilitation and enhancement of the economic process in such a way that helps in the management of risk and absorption of shock (Schinasi, 2004). The outcome of such researches is the focus of this essay, using specific cases to explain the relationship between market structure and financial stability. Relationship between perfect competition market structure and financial stability In perfect competition market structures, there is overall market activity that does not go in favour of a specific market player. This means that almost all banks have a fair ground to compete against each other. Meanwhile, Schinasi (2004) observed that for there to be financial stability, there are key indicators that must come to force, two of these hedging of risk, and operation of payments and settlement systems. However, within such perfect competition market structures, there is an overall attitude of banks in raising loan interest rates, whiles lowering account interest rates (Alleyne and Waithe (2009). When banks behave this way, there is a consequential effect on the attitude of investors, whereby they are noted to venture into risky portfolio management with the goal of getting their returns within the best shortest time frame (Robinson, 2005). As a result, the tendency of that investors will be prompted to hedge risk is very low as they would rather want to go over and above the risks. Because of the gains that the banks make from the borrowers in such concentrated markets also, it would be noted that the banks hardly have any need to operate payments and settlement systems (La Porta, Lopez-de-Silanes and Shleifer, 2002). From the parameters given above, one can expect that the variables needed to achieve financial stability such as the ability to facilitate and enhance economic processes, manage risks and absorb shocks all become absent, resulting from inactivity from the banks (Schinasi, 2004). The reason such lack of ability to facilitate and enhance economic processes will not be present is that the concentrated banks will be forced to focus on their inter-bank competition that ensures that they survive in the perfect competition market structure rather than taking responsibility for macro economic growth (Maudos and Guevara, 2004). In effect, perfect competition market structures are full of microeconomic activity to the disregard for macroeconomic activities. Explaining why the latter is so, Maudos and Guevara (2004) mentioned that in most concentrated banking markets the highest bidders are private banks that hardly have any control over macroeconomic variables. Relationship between monopolistic market structure and financial stability The situation is not always the same with monopolistic competition market structures, where state-owned institutions are mostly seen to have an advantage on the market. This is because since the state-owned institutions are directly run by government, there is active government borrowing on the market, hedging of risk and maintenance of monetary stability (Schinasi, 2004). Meanwhile these factors are always needed to achieve financial stability. What is more, state-owned institutions which control the monopolistic competition markets always target specific industries, giving soft loans and low interest rate loans. This way, the industries and investors are motivated to be engaged in prudent and less risky investments. As part of the prudent management of their investment, investors are more likely to practice finance based practices including hedge risks, which bring about financial stability. Another important factor that leads to financial stability among monopolistic competition market structures is the fact that because these markets are largely controlled by the state-owned institutions, it is possible to conduct monetary policy with the use of the bank’s resources. Meanwhile, it has been said that where there is active macroeconomic management, the possibility to achieve financial stability is higher. Through the various macroeconomic management processes that the state-owned institutions controlling the monopolistic markets put in place, the ability to facilitate and enhance economic process goes higher. Meanwhile, whenever there is such ability to facilitate and enhance economic process, the resulting outcome is financial stability, especially when other factors like management of risk and absorption of risks are all controlled. Conclusion In conclusion, it can be said that monopolistic competition allows for more financial stability as compared to perfect competition. This is because in most cases of monopolistic competitions, it is the government institutions that control the market. Meanwhile, these government institutions have absolute control over the macroeconomic indicators that bring about financial stability. The paper showed that for there to be financial stability, there ought to be government borrowing in the markets, which is a situation that is not common in perfect competitions. Hedging of risks must also take place among industry players, which is a situation created with monopolistic competition market structure. References Alleyne A. and Waithe K. (2009). Financial Development and Market Structure. Cave Hill Campus: Barbados. Garry J. Schinasi (2004). Defining Financial Stability. IMF Working Paper: Geneva. La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2002). ‘Government Ownership of Banks’ Journal of Finance 57 , pp. 265-301. Maudos, J., & Guevara, J. (2004). ‘Factors Explaining the Interest Margin in the Banking Sectors of the European Union’, Journal of Banking and Finance, 28, pp. 2259-2281. Moore, W. (2009). Management Practices and the Performance of Mutual Funds in the Caribbean. University of the West Indies, Cave Hill Campus: Bridgetown. Robinson, J. (2005). ‘Stock Price Behaviour in Emerging Markets: Tests for Weak Form Market Efficiency in the Jamaican Stock Exchange’, Social and Economic Studies, vol. 5 No. 2, pp. 51-69. Read More