How the Various Levels of Market Power Can Influence the Efficiency and Stability of the Bank - Literature review Example

Reference Report Summary This article under study examines how the various levels of market power can influence the efficiency and stability of the bank from the perspective of developing countries. It gives more information on competition and stability by analysing and documenting the complicated interaction existing between the different variables that are core for the policy makers such as, bank cost and profit efficiency, the extent or degree of market power, and general stability of the firm. The outcome of this study indicates that increasing the degree of market power results in higher bank stability, thus enhancing the profit efficiency in spite of the significant losses in efficiency cost. Specific comments In general the author’s awareness with regards to this paper is that is being examined is as follows: This article under study is a total contrast to the findings that were established by Schaeck and Cihak (2008). Cihak and Schaeck found a positive impact of competition on possibility in profit efficiency for US and EU banking. In the developing countries, banks which possess more market power are in a position to get more profits due to portfolio diversification. In the same vein, a study that was carried out using the Lerner conventional indices indicates that the banks that lend bigger parts of their assets are not profit efficient when compared to their counterparts (De Nicolo, 2000). According to Boyd and colleagues, the banks that lend a bigger portion of their assets enjoy a more significant level of overall stability of banking and potential risk reduction. The studies in relation to the developing nations, therefore, are in support of tradeoffs between bank stability and competition (Boyd et al., 2006; Schaeck et al., 2009). In developing nations, banks that have a price markup that is higher compared to the marginal costs, may improve their efficiency in profit, but when it comes to cost efficiency they do not perform well. As the regulatory and geographical boundaries move away and the utilisation of information technologies going a notch higher, the global paradigm of banking may develop to establish new chances for managers of the banks charged with the responsibility for making sure that their banks post higher returns (Berger et al., 2009). The negative relationship between the degree of the banks’ market power and the cost efficiency stands in all Lerner’s specifications. This is an indication that banks that have high market power found in the developing countries are not capable of attaining a lower efficiency in costs while carrying out cost reduction contrary to their peers. According to Hughes et al., (2003), they noted that the management can signal the market power simply by having excessive spending and large offices. Sengupta (2007) explored the effect of competition on credit access by the organisation by perceiving the banks competition as one between various symmetrical informed principals. He established a concept to expound the perceived bias (that appears to be very active in countries that are developing) of the large domestic and foreign banks, whereby small firms are neglected and only big companies are being given the priority when it comes to lending. But well informed local banks are finding market among the small enterprises. The studies of Lensink et al., (2008) established that the foreign ownership impacts negatively on the efficiency of the banks. Recent dimensions on global banking have modified the prevailing systems, and can carry some implications concerning the industrys ability. While the studies on efficiency of banking is wide, only a few literature have examined the effect of the market prevailing systems on efficiency with regards to financial service delivery and most so in relation to developing nations (Maudos et al., 2008; Delis and Tsionasi, 2009). This article under study goes further to examine the impact of market power pertaining to banks stability and efficiency matters in developing economies where capital market appear to be underdeveloped, and the main credit providers to the economy are the banks. The developing nations are the best examples to be used in investigating competition issues since they are deeply engaged in deregulation process, privatisation of the banks, and the liberalisation of finance, even as consolidation is being witnessed in the industry. The change of bank system indeed raises eyebrows about conditions of competition, financial service delivery efficiency, and the bank overall stability. The issues above are of importance in the presence of the severe effects as a result of the recently financial crisis for the developing nations (IMF, 2009). Another important aspect that this article under study establishes is the fact that this study has elaborately addressed issues of complex interaction existing between efficiency and stability, competition from the developing nation’s point of view. In the same vein, this study examines the relationship between core variables of market power, interest, stability and efficiency. Most importantly is the incorporation of the Lerner concept by the author that is the bank’s level of measuring the magnitude of competition. The study also establishes that since people acknowledge that there is no agreement in various studies in respect to this topic as to which is the best strategy that can be employed in the verification of the market power in relation to banking (Carbo et al., 2009), this article under study saw it wise to incorporate the three different approaches of Lerner index. Apart from the known traditional price markup in relation to the estimations of the marginal cost (Berger et al., 2009), this study used a structural concept to obtain other two Lerner adjusted indices namely efficiency adjusted and the funding adjusted (Koetter et al., 2008). The feelings of the writer of this article under study are of the opinion that the bank efficiency and stability may impact the magnitude of the market power, leading to an endogeneity bias concerning the Lerners traditional estimations. This is why the author saw it wise to use the Lerners three different approaches because they are more likely to give a better explanation to the developing nations. The overall results of this study under investigation show that banks possessing more market power have a significant efficiency cost losses; however, they always find avenues to better their returns. The arguments of Berger and Hannan (1998), were of the opinion that the banks that are not always exposed to stiffer competition are not as efficient as their peers who are faced with severe competition. In situations where the market power prevails, the managers may decide to peruse objectives rather than maximisation of profit. In comparison to the vast studies on the efficiency of the banks, investigations on the link between bank efficiency and the market structure covers only a small part of the developed market and it is not parametrical in the developing nations (Berger and Humphrey, 1997). Casu and Giradone (2006) established that bank efficiency estimations with the aid of non-parametric analysis of data envelopment approach. It consisted of a variable that was exogenous which was used in the evaluation of the PR H-statistics. Using a case study of banks within the European Union, the results did establish that there was no any vivid relationship existing between competition and the bank efficiency. However, studies of Maudos and De Guevara (2007) proved that a positive relationship existed between cost efficiency and market power in the banking system in Europe, thereby nullifying the hypothesis of the quite life. From the traditional competition fragility point of view which is of the opinion that the market power in the banking system may be desirable, besides the possibility of income efficiency losses. Banks with more market power are capable of lowering the information problem asymmetry and create a good relationship with firms individually (Petersen and Rajan, 1995). The incumbent banks are synonymous with screening borrowers and also differentiating them between high and low-quality debtors (Cetorelli and Parettto, 2000). This may assist in enhancing loan portfolio and improve the stability of the bank. The emergence of the recent counter trend both on the empirical and theoretical levels in support of the competition stability concept and dismissing the famous trade-off existing between bank stability and market power. The work of Canninal and Matutes (2002) indicated that banks that have monopoly power experience monitory costs and are prepared to give loan portfolios that are risky. Beck et al., (2004) reported that the stability of the bank is fostered in both the competitive and highly concentrated markets. On the same note, the arguments of Allen and Gale (2004) were that this existing relationship is complicated and dependent. Boyd and De Nicolo (2005), the effects of market power should be analysed separately for the case of loans and deposit markets. Banks that have excess credit market power are capable of charging loan interest rates that are extremely high to their customers. As a result of this action, individuals who borrow loans are put in a compromising situation in terms of repayment of loans, thus exacerbating the moral perilous incentives thereby shifting into projects that are riskier. Schaeck et al., (2009), used PR H-statistics in proving that banking markets that are competitive appears to be steady than their monopolistic peers. This article under study can also be echoed for highlighting the problems that come along with the use of the Lerner’s estimations conventional index. The first challenge is with regards to the hypothesis of the efficient structures that is of the idea that stability and efficiency may be propelling the market structure, with the reverse causality likely to exist between the interest variables. The second challenge in relation to Lerner’s traditional estimations is that there is a high likelihood of the marginal cost to reflect some aspects of the monopoly power that has increased in the deposit market. This is relied upon the banks’ ability to raise cash at a relatively cheaper cost. Ideally when it comes to the pricing of loans, the managers of the banks generally cover funding costs of their banks, risk premium factors so as to cover the uncertainty that engulfs loan contracting issues, and in addition to this, an extra premium is charged to cover the activities with respect to their market power. Therefore, certain aspects of the deposit market power are always readily reflected in loans pricing. Mandos and De Guevara (2007) argued that, inclusion of the financial costs and at the same time price of deposits appearing in the cost function covers the impact of the market power with respect to banking, may still lead to a bias result. If the funding costs are excluded, the possibility is that one is more likely to get a clean or raw authority of banking market power that is not altered by the market power originating from the market deposits while one is raising funds. This study under investigation also summarises the three specification of Lerner as below. In contrast to the conventional index, the adjusted efficiency of Lerner explains the relationship existing between efficiency and competition. Therefore, it may give a better foundation to investigate the effects of the magnitude of the market power on matters of stability and efficiency. Lerner’s index covers the necessity of pricing power since it measures the disparity between the price and the marginal costs given as a percentage of the price. In reality, the output price must take into account the amount of deposits and loans separately. However, statistical information fails to give enough basis that can estimate separate rates or prices for deposits and loans. The revenues from loans cannot be separated from the ones received from the fixed investment income, and the expenditure on the interest on deposits cannot be taken away from the interest that is paid on the other liabilities. A number of academic works have intensively and extensively researched the bank efficiency concept with the aid of applied and theoretical models (Berger and Master, 2003). Cost and the profit efficiency extent measures how sound banks are predicted to act in comparison to other banks providing the services as they do in the market. Because of the intermediation strategy, banks are structured as the financial intermediaries who collect the bank deposits and liabilities then transferring them into assets that can accrue interest e.g. investments and loans (Sealey and Lindley, 1977). This study under investigation also establishes that the Z-index assesses the banks overall stability according to the Lerner method of calculations (Berger et al., 2009). This authority of the bank balance incorporates the indicators of Leverage, Profitability, and volatility return into a single measure. It does provide data with regards to the sum of the standard deviations figures by which the profit will have to decline with before the depletion of the bank’s capital. It has been established that the indicators of the banks stability will increase with an increase in capitalisation and profit levels, and can also reduce the unstable deviation with respect to return on assets. It can also be said that increase (decrease) seen in the Z-index implies decrease (increase) in the bank exposure risk and also more (less) the bank stability. The measures of the banks security show that, averagely, banks that are operating in the developing countries that are found in the middle east are more exposed to risk potential that is lower if when compared to other regions. This result is corroborated with the aid of the Z-index and the risk-adjusted Lerner’s with respect to returns. Examining the table 2 of this study by Turk-Ariss, the banks that are operating in the Middle East tend to lend lower proportion of their assets when compared to the banks in other regions. In most cases, they depend primarily on some of their assets such as the use of funds, This perhaps could explain the reason as to why they are enjoying big revenues and are stable, leading to the high Z-scores and the risk –adjusted rates with respect to return on average. This article under study also indicates that the portfolio composition of the bank and its size, indeed are not important determinants of the cost efficiency when the conventional Lerner strategy is employed, however the coefficient in relation to the total assets frequently turns positive when the funding-adjusted and efficiency of the Lerner approach are applied. This shows that, in accounting for the endogeneity bias, the bigger banks are in a position to obtain or attain efficiency cost levels that are high. The presence of the foreign banks is linked with reduced level of efficiency costs, but this outcome is only applicable in cases where the Lerner’s adjusted efficiency is employed. Regulatory conditions with respect to the legal rights are of little impact to efficiency costs while increased economic development is highly negatively linked with the bank cost efficiency. This study under investigation has also established that banks in overall do not react favorably to higher magnitudes of the market power in relation to checking costs more effectively. It is of significance to verify if they (banks) are in a position to yield more revenues or even improve their activities in relation to lending. Banks that lends a big portion of its assets shows higher Z-indices, indicating that companies or firms that have that have greater risk in terms of credit (higher loans in relation asset ratios), indeed are expressed to a reduced level of the bank risks. This can perhaps explain why the banks that are operating in the developing economies that appear to be very active in giving credit to the firms’ in the economy normally hedge their portfolios. At times, they even tend to hold large equity capital so as to lower their potential risk and also to ensure that the overall stability is guaranteed and safeguarded. This could prove to be critical keeping in mind that the capital markets do not exist in the least developed nations and the bank are the primary source of credits for the firms. As the markets start to be more concentrated and the banks begin to gain market power, the financial conglomerates existing in the developing countries are most probably inclined to reap big because of the little variability in relation to returns and financial stability in general. In summary, empirical examinations for the developing economies indicates that a high degree of the market power leads to the profit efficiency returns and improved bank stability. For the analysis of the marginal impacts of a bigger level in relation to the market power of significant variables related to interest, at the bottom row of table four and table five gives the computed power of market. To crown it all, when the banks operating in the developing countries are enjoying a bigger degree with regards to market power, what ideally happens is that, they do not always manage their costs in an efficient manner. But rather they are in a position to attain big profits efficiency at the same time obtaining greater firm stability. The minor comments in regards to this paper under study Since majority of the developing countries have started to embrace liberalization of finances as a way of attaining bigger financial services all over the world, the bank system slowly is moving towards universal system of banking to give a full range of the financial services that is incorporated under the financial; conglomerates. This study that is being examined has not extensively covered the relationship between the financial stability and competition in relation to the developing countries and that there is no agreement whatsoever for the study on the effect with respect to banks stability and market power. Therefore, a lot of research should be carried out in relation to this issue. The article under study also does not show the banks in the developing economies commands enormous price make up over the marginal cost, and yet they do not perform well in cost efficiency levels. Thus, the paper under study should have elaborated further on this. This calls for further research work in the future studies. Also according to the studies in relation to this paper that is being examined, it has been established that competition may undermine the bank’s stability. This can bring confusion because many people are of the opinion that that competition improves the service delivery; thus how it can now undermine the stability of the banks’ leaves many questions unanswered. Therefore, more work should be done in this area to ascertain the whole fact. References Allen, F., Gale, D (2004). ‘Financial intermediaries and markets.’ Econometrica. Vol 72 (pp 1023-1061) Beck, T., Demirguc-Kunt, A., Maksinovic, V (2004). ‘Bank competition and access to finance: International Evidence.’ Journal of Money, Credit and Banking. Vol 36, pp (627-648) Berger, A., Hannan, T., (1998). ‘The efficiency cost of market power in the banking industry:’ A test of “quite life” and related hypothesis. The Review of Economics and Stability. Vol (80) pp, 454-465 Berger, A., Humphrey, D (1997). ‘Efficiency of financial institutions:’ International survey and direction for future research. European Journal of Operation Research. Vol (98) pp 175-212 Berger, A., Mester. 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