Impact of Bank Regulations, Market Structure, and Institutions on the Cost of Financial Inter-mediation - Term Paper Example

Impact of Bank Regulations, Market Structure, and s on the Cost of Financial Intermediation-A Critical Review Introduction It is well established that the efficiency with which financial intermediaries particularly banks intermediate capital has many important implications on economic growth (Kunt et al 2004). Hence, the determinants of the cost of financial intermediation are important issues to be researched .Many studies have been done to examine the determinants of the cost of financial intermediation (Kunt and Huizinga, 1998). Among these, the impact of bank regulation, market structure and institutions on financial intermediation have been debatable issues. This essay critically examines the theoretical and empirical literature on the impact of these three on the cost of financial intermediation. The next section critically reviews the available theoretical literature in this regard. Section 3 critically discusses the empirical evidence and section 4 concludes. 2. Theoretical Literature Review According to the theoretical literature, there are different views on the impact of bank regulations, market structure and institutions on the cost of financial intermediation (Pyle, 1971). Based on one view, it is suggested that creating obstacles to competition and monopolistic power through bank regulations, can adversely affect the efficiency of banks. This is because in this case, some banks will be more powerful which prevent competition and this can adversely affect the efficiency of banks (Kunt and Huizinga 1998 ). Thus according to this view, competition between banks positively affects efficiency. In other words, high concentration prevents competition and adversely affects the efficiency of banks. Another view is that the banks which are more efficient have high market share and low costs .This theory supports competition by arguing that competition helps banks to earn great market share and high efficiency(Demsetz,1973 ). Based on this view, competition and concentration are not in opposite directions. Rather, competition promotes concentration and hence bank efficiency. However, this theory assumes that there are no efficient barriers to entry. According to this view competition increases concentration only if the banks, which have high market share have a special advantage in developing output which are not available to other banks. In such a case, it leads to increased efficiency of the banks, which have this advantage (Demsetz,1973 ).Here, the profits will not be reduced by competition since it will be very difficult for other banks to overcome the superior performance using their inputs. This is because, in this case, it is not the inputs but the owners detain the advantage of the superior performance. Peltzman(1977) goes into the details of this by decomposing efficiency of banks into cost efficiency and price efficiency and examines the impact of concentration through competition on both efficiencies based on a theoretical model..The price efficiencies were obtained to be absent while the cost efficiencies dominate his results. According to this view, any anti competition measures can adversely affect the efficiency of banks. At the same time, Berger et al (1999) through his theoretical framework suggests that increased concentration through mergers and acquisitions seems to have no cost efficiency effects but result some improvements on profit efficiency. Thus, this is a theoretically ambiguous result. However, the main problems with this view are that it implicitly assumes that there are no efficient barriers to entry, which cannot be realistic. Further, it does not take into account the information asymmetry problems, which can adversely affect efficiency. Many studies have shown that in the presence of information asymmetries and significant barriers to entry, this can adversely affect efficiency (Boyd and Prescott(1985). A third view focuses on the role of institutions in determining the bank efficiency. Based on this view, the regulations and concentration of banks are part of the overall institutional environment rather than the independent determinants of the bank efficiency (Kunt et al 2004,Boyd and Prescott 1985).This view point suggests two alternative explanations .One is called the law and finance theory .The other is called the endowments and finance theory. According to the law and finance theory, differences in the legal traditions of a country play an important role in determining the institutional characteristics and bank efficiency. Some countries have legal traditions that do not protect their private investors’ rights and places more importance to the state and restricts competition. This is mainly in relation to the French civil law and British Common law. While the British Common law gives much importance to the shareholders or the investors, the French civil law gives much importance to the stakeholders and the state (Kunt etal, 1998). Since the French law gives less importance to the property rights of the investors, they have more powerful legal systems. This will result in allocating the resources from optimal to more favored ones. This will in turn hinder competition and thereby restricts efficiency. Thus, countries that have more powerful legal systems and less emphasis on the private investors’ rights will restrict competition and thus will lead to inefficiencies in banking system. According to the endowment theory, the differences in legal traditions do not play much role in determining the institutional environment. Instead, the differences in the geography and the disease environment play main roles in determining the institutional environment of a country. This approach focuses on the differences in the colonization strategies adopted by the countries. Some nations like United States, New Zealand and Australia in their colonization process focused on settling down and building institutions. On the contrary, some other nations like Congo, Ivory Coast and Latin America rather than settling down focused on extracting as much as possible from the colonies rather than institution creation for protecting the property rights of private investors (Kunt etal, 1998). In other words, the governments here persuaded the people to extract from the colonies instead of institutional building. Thus, the geographical factors played an important role in determining the institutional environment according to this viewpoint. In addition to the geographical factors, another factor that plays a major role in the institutional determination is the disease-setting environment according to the endowments and finance theory. This mainly focuses on the mortality rates in nations. Nations which had high mortality rates engaged in extracting from the colonies as much as possible due to the unfavorable environments existing in their countries. At the same time, nations, which had, favorable environments focused on creating institutions and protecting property rights. Thus, the disease-setting environment plays a major role in the institutional building process in a country according to this viewpoint. A third stream of literature based on the endowment and finance suggests that the colonies which had an extractive environment even after independence tried to make use of the previously existing environment (Kunt etal 1998). Instead of building institutions and protecting the property rights of investors, these independent colonies again engaged in extracting from the previously existing environments. On the other hand, the settling colonies after independence focused on building on the previously created institutions and protecting the property rights of private investors. Thus, in these nations through the emphasis on private investors and protecting their property rights, a more efficient and competitive financial system especially the banking system was developed. On the other hand, in the extractive nations, there have been sever restrictions to competition since they placed only less importance to the private investors and the protection of property rights .This ,in turn resulted in an inefficient financial system particularly banking system in these countries. The institutional view thus suggests that institution building like protecting the property rights of private investors play determine the efficiency of banking system. According to this view, the overall institutional characteristics in a country rather than bank regulations and concentration in isolation determine bank efficiency. However, the main limitation with this approach is that this focuses mainly on European nations and USA. The whole theory is discussed from the viewpoint of these nations. This theory ignores the case of developing nations, where the geographical conditions and the legal systems are much different. Hence, the explanations for the institutional building and the bank efficiency in these nations will also be different, which is not covered by this theoretical viewpoint. This section thus critically reviews the theoretical literature on the three major viewpoints ie the bank regulations, market structure and the institutional viewpoints regarding the bank efficiency. The next section examines the empirical literature review in this regard. 3. Empirical Literature Review Many empirical studies have been done to examine the determinants of bank efficiency. Kunt and Huizinga (1998) examined the determinants of bank profitability and interest margins for 80 nations from 1988-1995. According to this study, bank characteristics like competition, capitalization, differences in a bank’s activity and entry of foreign banks affect the bank profitability and net interest margins. Macroeconomic characteristics like inflation, explicit and implicit bank taxes and the legal and institutional characteristics also influence the bank profitability and net interest margins. Among the bank characteristics, more competition was found to result in less profitability and small interest margins while capitalization was found to have a positive impact on bank efficiency in terms of both the indicators used here. Variations in the activities of banks like differences in non-interest earning assets, reliance on large deposits, differences in overheads and other costs were found to have different impacts on the bank profitability and net interest margins. Inflation was found to have positive impact on profitability and net interest margins. Legal and institutional characteristics like better contract enforcement, more efficient legal system and lack of corruption were found to have negative impact on bank profitability. However, the main limitation of this study is that this study fails to capture the country specific differences. There are many differences in the regulatory structure of banks as well as the legal and institutional environments between both industrial and developing nations. In this study, these two nations have been examined together to analyze the impacts. Caprio et al (2000) based on a dataset for 107 nations empirically examined particularly the impact of bank regulations on bank development and fragility. In this study, the measures to proxy regulation include regulatory restrictions on bank activities and the mixing of banking and commerce; domestic and foreign bank entry regulations, regulations on capital adequacy regulations, deposit insurance system design features , supervisory power, independence, resources, loan classification stringency, provisioning standards, diversification guidelines, and prompt corrective action powers, regulations on information disclosure that foster private-sector monitoring of banks and government ownership of banks. To represent the bank performance and fragility, the measures used are bank development, net interest margins, overhead costs, non-performing loans and a banking crisis variable. The results suggest that excessive regulatory and supervisory policies adversely affects bank performance while the policies that force accurate information disclosure to empower private-sector monitoring of banks and create incentives for private agents to monitor banks helps in promoting bank performance and stability. Caprio et al (2003) also examines the effects of ownership, shareholder protection laws and regulatory policies on the valuations of banks using a new large database for 244 banks across 44 nations. The results suggest that official supervisory and regulatory policies do not significantly affect the valuation of banks. The results suggest the main factors that help in increasing valuations as large cash flow rights by the controlling owner and strong shareholder protection rights. In addition, the results suggest that the negative impacts of the weak share holder protection rights on valuation are mitigated by the greater cash flow rights by the controlling owner. The main limitations with these two studies are that they also ignore the cross-country differences in their analysis. This will become particularly significant since the focus of this study is on the regulatory policies. This will be different in different nations. Hence, generalized results will be problematic. Moreover, the study does not control for the macroeconomic, legal and institutional characteristics, which can have great impacts on bank performance and stability. There are many studies, which have examined these effects. Kunt and Maksimovic(1998) examined the effects of legal and financial systems for a sample of 30 developed and developing nations on the efficiency to obtain external funds for growth. The study obtained well-developed legal and financial systems positively affecting the growth of firms .In countries that have well developed stock markets and banks with efficient legal systems were obtained to be more capable in getting external funds than their counterparts. This study thus supports the institutional view in determining economic performance. This study, however, also suffers from the problem of ignoring country specific differences. Acemoglu (2001) examined the effect of endowment and finance theory in many European colonies based on the European mortality rates on the economic development in these countries. The results suggest that the endowment and finance theory significantly affecting economic growth in many of these nations. Beck etal(2002) empirically examined the evidence for law and finance theory and the endowment and finance theory on financial development for a sample of early colonies. Though the empirical evidence supports both theories, endowment theory fits more for financial development. In other words, geography and initial endowments were obtained to be the major determinants of financial development rather than the legal characteristics in this study. These two studies empirically examined the institutional view of financial development and economic performance. The results of both support the institutional viewpoint. The main limitation with these studies is that they only focus on European colonies. It will be problematic if the results obtained are generalized to other nations due to the different institutional environments existing in these nations. Further, both the studies fail to capture the time varying effects and the country specific effects. The study by Kunt et al (2004) examined the effect of bank regulations, market structure and institutional characteristics on the net interest margins and overhead costs using a large and well-developed database for 1400 banks across 72 nations. The study controls for the bank specific and macroeconomic characteristics like inflation. In this study, the results support the institutional view for bank efficiency. Though the results suggest heavy regulations on bank entry and bank activities increasing the cost of financial intermediation, these results lose significance while controlling for institutional characteristics. Inflation appears to have a positive impact on net interest margins and overhead costs. The institutional characteristics appear to be the robust determinants of net interest margins and overhead costs in this study. Better protection of property rights will enhance competition, which in turn will positively affect net interest margins and overhead costs as obtained from this study. The bank concentration is found to be insignificant while controlling for regulations and inflation. The results thus suggest that the bank regulations and supervisory policies are part of the overall institutional environment rather than independent determinants of bank efficiency. This study however, suffers form the problem of ignoring country specific effects and time specific effects .In addition, Strahan (2004) while commenting on the above study has shown that though the better protection of property rights will finally have a positive impact on the net interest margins and overhead costs, it will ultimately benefit bank borrowers rather than lenders. This aspect is not covered in the Kunt et al (2004) study. In other words, the net interest margin is not divided into interest on loans and interest on deposits. 4. Conclusion In this essay, the theoretical and empirical literature on the impact of bank regulations, market structure and institutions on the cost of financial intermediation has been critically reviewed. The theoretical review shows three viewpoints in this regard. Though the empirical studies obtained mixed results in this regard, most results support the institutional view .Thus, the results suggest that bank regulations and supervisory practices are parts of the overall institutional environment rather than independent determinants of bank efficiency. In addition, institutional characteristics of countries explain mainly the cost of financial intermediation. However, more country specific studies are needed on this regard to get clear and specific results. References Berger, A N., Gerald A. Hanweck, and David B. 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