Bank Efficiency And Financial Intermediation - Case Study Example

 Bank Efficiency And Financial Intermediation INTRODUCTION The banking industry has been established well over 100 years since which it has played a vital role in the economy of countries and the world at large. Banks are used to keep the savings of the public safe and in return use it for the development of business and trade. In order to review the impacts of regulations, market structure and institutions, it is important to first examine the theories of financial intermediation and its implications in the banking industry. According to Allen & Santomero (1998) the efficiency of the financial intermediation affects the country’s economic growth while on the other hand it can result in the systemic crisis having adverse impacts on the whole economy. In addition, Kunt et al. (2003) said that banks are institutions that assemble savings and allocate them in the society thus having substantive repercussions on the economic performance by their efficiency of intermediating capital. Therefore, stakeholders of banks such as regulators, investors and public have a keen interest in the performance of the banks. CRITICAL REVIEW OF THEORY OF FINANCIAL INTERMEDIATION The financial intermediation as told by Mishkins & Eakins (2005) is an omnipresent feature of the economy not just for one country but for the world as whole. Allen & Santomero (1998) explains that the theory of intermediation clarifies why financial intermediaries exist and the risks they take in the financial market. Many theories according to Scholtens & Wensveen (2000), given in the past relate to the market based theory that markets are in perfect equilibrium and no intermediary is required, whereas in reality this theory is subject to contradiction as development of new techniques and equilibrium theory have emerged in the criticism. The roles played by the banks and insurance companies as intermediaries in the financial sector have been discussed in the theory known as intermediation theory (Scholtens & Wensveen, 2000). The foundation of these theories is on the resource allocation in perfect markets by suggesting that the friction such as transaction costs and asymmetric information are vital in the understanding of intermediation (Allen & Santomero, 1998). Scholtens and Wensveen (2000) argue that the current theories of financial intermediation rely on the functions of financial institutions which bear no importance in this era of financial systems. The role of intermediaries in the reduction of transaction costs’ frictions and asymmetric information is very vital (Scholtens and Wensveen, 2000). Allen and Santomero (1998) argue that many past theories on intermediation do not take into certain factors such as the changing structures and banking systems. According to recent theories, described by Scholtens & Wensveen (2000), institutions, banking regulations and laws are important in the assessment of financial intermediation. To base a theory on the constant factors as suggested by Gorton & Winton (2002), is useless as the features of intermediation keep changing over time due to market changes, regulations and evolution of institutions. COST OF FINANCIAL INTERMEDIATION Cost of financial intermediation can be considered as the participation cost in the financial system by the financial intermediaries. According to Hermes & Lensink (1996) the cost of intermediation depends on the size of the financial market that is the availability of capital for intermediation. If an economy has a thick or concentrated financial market, the cost of intermediation will be low as the fixed costs will have a wider spread (Hermes & Lensink, 1996). In contrast, small financial markets will have higher intermediation costs due to low capital. The cost of financial intermediation according to Kunt et al (2002) is the function of net interest margin of the banks and its overhead expenditures. The simplest definition of net interest margin is the sum of interest income minus the interest expenditures divided by interest-bearing assets (Kunt et al. 2003). By using the net interest margin, a bank can determine the gap between the payment made to the bank’s savers and the amount received from the borrowers. In other words, it can be said that the net interest margin is related to the conventional lending and borrowing function of the bank. The other function of cost of intermediation, overhead expenditure, is measured by dividing the overhead costs of the bank with its total assets (Kunt et al. 2003). Overhead costs can reflect on the bank efficiency and its market power. If the overhead costs are high, it points to cost inefficiencies. The previous researches mentioned by Gorton & Winton (2002), carried out on this subject provide empirical evidence that has ambiguous results. Some researches according to Gorton & Winton (2002) imply that the banks in concentrated markets have large overhead expenditures therefore they charge high rate of interest on loans, pay low rates on deposits and thus are slow in responding to the Federal government’s reductions in interest rates as compared to the banks that are located in less concentrated markets. Many scholars disagree with this statement. Kunt et al (2003) pointing out the work of Smirlock (1985) and Grady and Kyle (1979) said that the interest rate spreads are narrow in banking systems that are concentrated while other scholars suggest that a best performing bank are not located in heavy concentrated markets. The relationship between the bank efficiency and bank concentration depends on factors that are held constant as many factors are acting upon the relation simultaneously (Gorton & Winton, 2002). For example, research was carried out by Kunt et al. (2003) to assess the impact of regulations, structure and institutions on cost of intermediation who believed that the banks differ within countries as well across countries. But in this study, the factors of macroeconomic influences have been controlled to assess the robustness of the impacts on cost of intermediation. The result of the study has been presented in the following parts of this review. Critical Review of Cost of Intermediation Many theories present divergent arguments about the relationship between regulations, institutions, structure and efficiency of banks (Gorton & Winton, 2002). These differences occur due to different views on the concentration of banks. One view suggests that the regulatory obstacles in the competition and monopolistic power create a scenario which is exploited by powerful banks to cause harmful competition (Kunt et al. 2003). According to this view, high concentration of banks is a sign of uncompetitive and an inefficient market. In contrast, the efficient structure theory suggests that the having lower costs create efficient banks and thus gain more market share (Kunt et al. 2003). According to this view, this scenario caters competition creating concentrated banking systems. IMPACT OF BANK REGULATIONS The financial system in the world is the most heavily regulated industries. According to (Mishkin & Eakins, 2009), he said that the bank regulations consist of eight categories. These include the government safety net for deposit insurance and FDIC, asset holding restrictions, requirements to maintain a minimum bank capital, the charter of the bank supervision, risk management assessment, specific disclosure constraints, standards for consumer protection, restriction of competition among the banks (Mishkins & Eakins, 2005). The study conducted by Kunt et al. (2003) focused on the regulations such as bank entry, requirements for reserve, bank activity restrictions and so on. The reason for doing so is to evaluate the degree to which banking regulations can hinder the banking operations and competitions. This in turn impacts the bank concentration and cost of intermediation. The results of this study showed that the regulatory restrictions increased the net interest margins (Kunt et al. 2003). The barrier to entry causes the existing banks to enjoy higher interest margins as well as restrictions in activities such as underwriting, real estate and so on increase the interest margins for the banks. These results are true if the factors such as bank concentration and inflation rate are kept constant (Kunt et al. 2003). No counter argument has yet been suggested in respect to these results, although, it is argued that bank regulations cannot be isolated from the institutional framework as they present a broader framework for the banks in the economy (Fethi & Pasiouras, 2009). In addition to this, it has been found out by Kunt et al. (2003) that the research does not identify any benefits that the regulations can bring in the cost of intermediation given the freedom in terms of bank valuations, stability of the bank and so on. Critical Review The banking sector is a vital channel through which instability can spread to other sectors of the economy through the disruption in the interbank lending market as well as the payments mechanisms and reduction in credit availability and freezing of deposits (Berger et al. 2009). Regulators have always been focused on the development of such policies that can create stability in the banking sector due to the fear of increased competition disrupting the financial system. Profit margins for the banks become less if competition increases thus forcing banks to take risks in order to increase the returns (Berger et al. 2009). Such situations are blamed on the liberalization of financial sector that has removed the barriers to entry and deregulation of interest rates. Many studies have been carried till date to examine the impact of regulations and liberalization on bank efficiency and performance. These studies indicate positive relationship in countries such as India, Pakistan, Australia, and China and so on (Fethi & Pasiouras, 2009). Although it is argued by many scholars, according to Fethi and Pasiouras (2009) that after a certain limit of deregulation no further productivity growth can be achieved. For example, the banking industry reform in the EU countries had a positive impact on the efficiency of bank while the effect on total factor productivity growth came towards the end of the reform (Fethi & Pasiouras, 2009). IMPACT OF MARKET STRUCTURE The market structure as explained by Norris & Floerkemeier (2007) is made of many factors such as ownership structure, concentration of banks within a region, competition and so on. These according to Norris and Floerkemeier (2007) have important repercussions on the banks’ incentives that drive them towards overcoming market frictions and effectively and efficiently perform the intermediation function thus reducing its cost. Many researches have been carried out on the relationship between market structure and ownership on borrowing and deposit spreads using cross country evidence. Some of the researchers such as Kunt et al (2003) have found a positive relation between the efficiency of intermediation and entry of foreign banks the assumption of which lies on the hypothesis that competitive pressures increase by the entry new foreign banks that results in higher intermediation efficiency (Norris & Floerkemeier, 2007). Market structure including the financial reforms, competition and ownership of the banks determine the depth of the cost of financial intermediation. Critical Review The relationship between efficiency of intermediation and bank entry has been criticized by many researchers who believe that the foreign banks have higher interest margins and leads to shallow credit markets (Norris & Floerkemeier, 2007). As it is commonly known, the structure of the financial markets around the world has undergone revolutionary changes over the two decades. Financial markets, as suggested by (Kunt et al, 2003), for example the bond and stock market have grown considerably. In addition, the financial innovations have accelerated throughout time to include products such as mortgage backed securities, derivative tools such as swaps, options and so on. New markets for securities and derivatives have emerged as major markets in the country and the world (Kunt et al. 2003). These new markets provide new opportunities for investment and risk management. The financial innovations came about also due new designs of security, advances in computer and telecommunications and most importantly the progress in the theory of finance (Schmitz, 2003). This increase in the financial market breadth wise as well as depth wise is due to excessive use of new instruments by the financial intermediaries. Even though the advent of technology has reduced the information cost and information asymmetry, it has not reduced the need for services rendered by intermediaries (Schmitz, 2003). Concentration of banks may reduce the asymmetric information as suggested by Hauswald & Marquez (2000) which can lead to enhancement in the role of banks, providing less default and efficient credit allocation. The frictions discussed in the beginning such as information asymmetry has not reduced the demand for intermediation. IMPACT OF INSTITUTIONS Financial institutions in the world are very well developed especially in the developed countries such as US and UK is able to offer many different borrowing tools (Kaplan & Salman, 2005). If the competition in the market is high, they can offer instruments least costly and avoid costs incurred by taxing thus reducing its cost of intermediation (Kaplan & Salman, 2005). The impact of institutions on the cost of intermediation is assessed using the indicators such as property rights protection and degree of economic freedom (Allen & Santomero, 1998). The aforementioned bank regulations also reflect in the broader sense the protection of property rights associated with the financial institutions. Therefore as explained and researched by Kunt et al. (2003), holding constant the variables of bank regulation in explanation of impact of institutions, they do not provide any information on the power of cross-bank net interest margins. Abundant literature as explored by Kunt and others (2003) on the impact of institutions on the cost of intermediation suggests that most countries have institutions whose policies reflect restrictions on competition in order to protect powerful banks in the region. This is known as the institutions view. This type of view reflects bank regulations and market concentration as part of wider institutional characteristics instead of focusing on independent factors of bank efficiency (Kunt et al 2003; Allen & Santomero, 1998). Critical Review The cost of intermediation impacted by institutions as noted by Norris & Floerkemeier (2007) involves changes in loan rates, enforceability of foreclosures, collateral information sharing with borrowers as well as market transparency in addition to the property rights that is explained by Kunt et al. (2003). According to Norris and Floerkemeier (2007), the cost of intermediation also includes fixed cost element at the financial system level. The size of the market and market failures can lead to undiversified risk causing the lending rate to include risk premium. Therefore the link between the bank size and the interest rate spreads is a negative one (Norris & Floerkemeier, 2007). The institutions view described above has been contradicted by Bianco, Jappelli and Pagano’s (2001) in the research by Kunt et al. (2003) suggesting that the impact of quality of institution on the interest margins is vague in theoretical context but does work well in the practical field. Bianco, Jappelli and Pagano’s (2001) indicated that the improvements in the environment of institutions consisting of better rights on property, contract enforcement and high level of judicial efficiency, all put effort in increasing the collateral value for loans resulting in reduction in the cost of financial intermediation. In contrast to this view, Kunt et al. (2003) points out that improvement in the institution environment can widen the scope of credit market to the low-grade borrowers thus raising the interest rate on loans. Such improvements therefore cannot show a clear impact on the net interest margins and the overall cost of intermediation. CONCLUSION In today’s world, many financial intermediaries can be seen aiming at reducing the distance between the borrowers and lenders (Fethi & Pasiouras, 2009). The theory of intermediation explained by Allen & Santomero (1998) clearly explains the reason for financial intermediaries’ existence and the risks associated with its operations. Therefore the impact of bank regulations, market structure and financial institutions on cost of intermediation is vital to known. The review conducted is a critical analysis of the theoretical literature on the cost of intermediation which is referred to as the participation cost in the banking or financial system. In this review, different views of authors and researchers have been presented who argue on the impacts on intermediation. One such author, Hermes and Lensink (1996) said that the financial intermediation cost depends upon the market size as well as the capital in the economy. Another author suggests that intermediation cost is based on the net interest margin of the banks and the overhead expenditures it incurs. Both the views are correct because they have been concluded in different research settings. By the conducting the review, it has been observed that the intermediation costs are closely linked with the bank efficiency and market power that can vary in each country and economy. The impact of bank regulations and market structure can lead to different variations in the efficiency of the bank thus causing high and low intermediation costs. Another factor affecting the cost is the competition which is explained under the broad heading of financial institutions. In addition to this, property rights and bank concentration in certain region tend to have significant impacts on the cost of financial intermediation as they can cause hindrances in the banking operations. The current financial market has changed a lot due to advancements in technology causing new financial instruments to be developed. This can also have an impact on the intermediation cost if the institutions are not efficient in coping with the changes. If the banks and institutions wish to minimize their costs, they should make their operations efficient and find locations that are not heavily concentrated. WORD COUNT : 2876 REFERENCES Allen, F. & Santomero, A. “The Theory of Financial Intermediation.” Journal of Banking and Finance. Vol.21 (1998.) Berger, A., Klapper, L. & Ariss, R.” Bank Competition and Financial Stability.” Journal Financial Services Research. Vol. 35 (2009) Bianco, M., T. Jappelli, and M. Pagano .“Courts and Banks: Effects of Judicial Enforcement on Credit Markets,” CSEF Working Paper No. 58, (2001). Fethi, M. & Pasiouras, F. “Assessing Bank Efficiency and Performance with Operational Research and Artificial Intelligence Techniques: A Survey.” European Journal of Operational Research (2009) Gorton, G. & Winton, A. Financial Intermediation. The Wharton Financial Institutions Center. 2002. Hauswald, R. & Marquez, R. "Relationship Banking and Competition under Differentiated Asymmetric Information" Wharton School Center for Financial Institutions Working paper 00-13 (2000). Hermes, N. & Lensink, R. Financial Development and Growth. Routledge Studies in Development Economics. 1996. ISBN 0415133920 Kaplan, C. & Salman, F. Intermediation Costs and Financial Fragility. 2005. Retrieved from http://www.google.com/search?hl=en&source=hp&fkt=124978&fsdt=129330&q=cost+of+intermediation&aq=f&oq=&aqi=g1 Kunt, A., Laeven, L. & Levine, R. “The impact of bank regulations, concentration, and institutions on bank margins” World Bank Working Papers (2003). Mishkins, F. & Eakins, S. Financial Markets and Institutions. Pearson Prentice Hall. 2005. Norris, E. & Floerkemeier, H. “Bank Efficiency and Market Structure: What Determines Banking Spread in Armenia?” International Monetary Fund: Working Paper. No.134. (2007). Schmitz, S. “The Effects of Electronic Commerce on the Structure of Intermediation.” Vienna University of Economics 2003. Retrieved from http://jcmc.indiana.edu/vol5/issue3/schmitz.html Scholtens, B. & Wensveen, D. “A Critique of Theory of Financial Intermediation.” Journal of Banking and Finance. Vol.24 (2000) Read More