Structure Conduct Performance Paradigm in Banking - Essay Example

Structure Conduct Performance Paradigm is widely used in assessing the performance of the banking industry. This research paper attempted to study and explain the SCP in banking by discussing some of the available literature on the subject besides analyzing the possibility of using efficient structure hypothesis and relative market power hypothesis for future empirical studies to be conducted on assessing the performance of the banks. Results suggest that the SCP may not be the valid empirical construct for assessing the firm performance in banking industry as the empirical studies conducted across the different geographical locations suggest that the despite structural changes into the banking industry, they are still competitive and hardly engage into collusive behavior. Introduction Banks tend to perform various tasks and roles within an economy and as such are considered as one of the most important pillars of an economy. The supply of credit to the borrowers and lenders is the basic function which a bank performs besides taking deposits. However; the nature and scope of the industry have broadened over the period of time. The recent crisis in the banking industry indicates to the extent of severity of the failure of financial system can be as it has the potential to impact the whole economy of a country. The severity and mass scale failure of banks to perform in relatively volatile market environment indicate how the overall performance of banks is worsening over the period of time. Numerous studies have been conducted in order assess the performance of the banking industry and its relationship with the market structure. These studies have divided or segregated the bank performance into different categories such as bank loan and deposit rates, profit rates of the bank etc. The structure- conduct paradigm is the major theoretical attempt to define the behavior of banks within a competitive environment. Though the Structure conduct paradigm or SCP as it is mostly called is an extension of industrial economics. However, it has been extensively used in banking industry to study the paradigm within the specific characteristics of the banking industry. This research paper will study and analyze the structure conduct paradigm in banking and would further discuss how efficient market hypothesis and relative market power hypothesis can have different implications for empirical studies to be conducted of the structure and conduct of the banking sector. Literature Review Over the period of time, the banking industry has increased in the scope as it attempted to capture different business such as insurance, mortgage finance etc into its ambit. This feature has given the banking industry a whole new orientation in terms of its structure and performance as its overall volume and reach within the economy consolidated. (Harris, 2000). Such attempts by the banking industry, therefore, also resulted into some serious structural changes not only in the banking industry of US but also in the banking sector of other developed countries. A new wave of mergers and acquisitions were witnessed into the industry as the focus was on developing financial institutions which could provide multiple services under one roof. Along with such a consolidation into the industry, there have been theoretical attempts too under which the attempts were made to study the banking from strategic management perspective. However, it is also critical to note that there was transgression from the other theoretical disciplines also as researchers attempted to use cross disciplined studies to extract the correlation between different variables. Structure conduct paradigm is also such a theoretical attempt to correlate industrial economics with the strategic management. As Dubin (1978) has outlined that it is possible that the one tenet of a discipline or theory may be contingent to set of parameters and boundaries that are basically not available to that theory or discipline. Therefore, the transfer of one idea belonging to a certain specific discipline or set of theoretical parameters may be applicable an entirely different set of theoretical assumptions if such ideas have the practical implications for that set of theoretical assumptions. . Structure conduct was therefore, was dominant paradigm into industrial organization as research studies focused on understanding the competitive behavior of the organizations. Structure- Conduct- Performance Paradigm Structure refers to the market structure, mainly defined through the concentration of market shares of different players in any given industry whereas conduct refers to the behavior or attitude of the firms in that industry i.e. whether the industry participants are collusive in their nature or engage into competition. Finally, the performance is identified as the social efficiency of the organization within the context of market power. Structure conduct performance paradigm, however, is based on certain hypothesis which basically attempts to link the structure with the conduct and performance. The theoretical assumptions for SCP include; 1. Structure influence conduct. 2. Conduct influence performance 3. Structure has the power to influence performance. According to this, the lower the concentration of market power, the more competitive firms are and if that concentration power is increased firms will start to collude with each other. Similarly, as the competitive behavior of firms becomes more competitive, less market power is enjoyed by the firms and as such the firms do not engage into collusion. Finally, the structure of the industry i.e. the number of firms in an industry increases the performance of the firms increase because the market power is tended to reduce when there are many firms in the industry. (Cetorelli, 1999). Structure- Conduct- Performance Paradigm in Banking With the increase in globalization of financial markets the overall social influence of financial institutions specially increased. Numerous studies have been done in order to ascertain the social influence of banks specially and this has been done within the context of the SCP. Structure-Conduct- Performance paradigm was the brain child of Harvard University and attempted to find empirical correlation between the industry structure and performance and resulted into the formulation of majority of anti-trust laws into US. (Edwards, Allen, & Shaik, 2006). Later there were different variations into this paradigm emerged too as the economists continuously tried to evolve from the past theories based on structure conduct paradigm. The last two decades witnessed enormous consolidation into the banking industry as the banks, due to their complex and sensitive nature were more prone to external risks. Therefore, policymakers focused on consolidating the banking industry in order to enable banks to absorb huge external shocks resulting into losses. (Northcott, 2004). It was therefore, a policy option that in order to maintain stability into the industry, some market power must be assigned to banks so that the overall functioning of the financial system remains stable. This was also. However, against the largely held belief that the perfect competition is right for the banking industry as there is large number of buyers i.e. depositors as well as borrowers who are using the banking services. The efficiency in banking is largely viewed from two perspectives i.e. allocative efficiency as well as productive efficiency. Allocative efficiency in banking largely concentrates on the ability of the banking industry to promote capital accumulation through extending the credit to economy. Allocative efficiency is, however, further viewed from the perspective of market power as well as the presence of information asymmetry. Productive efficiency, however, deals with the presence of perfect competition within the banking industry and outlines that if no economies of scale is present within the banking industry than there is a chance that the industry may be running under perfect competition where size of the firm and industry concentration would force the market towards productive efficiency. However, as discussed above that the financial innovation has resulted into the consolidation of the banking industry and there have been strong inter linkages between the banks across geographical locations even. Therefore, smaller shocks can produce bigger impacts for the sector due to contagion and as such the probability of the whole economy getting affected through such shocks are higher. (Allen & Carletti, 2008). As such the efficiency of the banking industry is largely dependent upon the degree of the extent to which the banking sector is linked with each other either through strategic alliances or through merger and acquisitions. There are various examples of such a behavior being reflected by banking sector of different countries. The Spanish Banking sector is largely considered as an oligopoly as banking firms often collude with each other to maintain their market power. Similarly, the banking sector in Latin America is largely based on strong domestic clouts which are not only restricting foreign entities to enter the market but also showing strong strategic bond with each other to withstand the external shocks and develop the capability of mitigating risk. The changes in the structure of the banking system of US, however, lead to a different mode where banks and financial institutions gradually developed as brokers as the overall role of the banks have changed over the past fifty years in US. (Hester, 2002). Historically, basic structure of banks was largely driven by the firms which were involved in taking deposits and making loans. However, as Allen and Carletti state that they ameliorate the information between borrowers and depositors besides smoothing out the risk which otherwise may not be shared across the market. What emerged within the structure of US banks is slightly different than what has happened within the EU region as this region has higher concentration of banks as in comparison to US where other financial institutions dominate too. As such the concentration of market power is diluted within the US banking industry. However; it is significantly more within EU and UK. It is also important to note that during last three decades banking sector witnessed a complete de-regulation with minimal government intervention. This, therefore resulted into the financial innovation as well as consolidation of the banking structure as banks started to offer bundled services under one roof. This change in structure of the banking system, especially in US and UK lead to higher efficiency as well as relative stability into the market. One of the critical phenomenon which was specially observed within US was the fact that small banks started to emerge on the regional level which basically gave rise to a banking structure which was relatively more competitive. Hester (2002) is also of the view that the Banks within US has gone through a transformation phase of congenric where banks basically attempted to develop themselves into one bank holding company. This change in structure of the banking industry lead to the increase in efficiency as over the period of last 20 years, banks within US have been enormously profitable due to their ability to make changes into the very structure. Further, it is also critical to note that the structure of banking industry within US remained largely fragmented with very few number of banks operating at the international level as most of the banks were catering to the regional demand rather than serving international customers. However, it is also important to note that the empirical studies also suggested that the increasing universality of the banks i.e. banks offering universal services under one proof does not result into the increased concentration of market power. Therefore, such structural changes do not result into the increased market power. (Fohlin, 1995). This study was conducted in Germany and outlined that despite such universality banks fail to engage themselves into anti-competitive behavior and avoid collusion. Efficient Structure Hypothesis and Relative Market Power Hypothesis Two of the most critical concepts which are often analyzed together with the SCP are the concepts of efficient structure hypothesis and relative market power hypothesis. The efficiency structure hypothesis defines the two measures of market concentration or market share determine the market performance of the banks and relate the performance of the firm as a direct proportion to its efficiency. Similarly, the relative market power hypothesis states that the “degree of market concentration is indirectly related with the competition in the industry. (Edwards, Allen, & Shaik, 2006). The historical studies being conducted on these two hypotheses have been largely within the context of the different performance indicators such as profitability and profit margins. However, empirical studies have also been conducted to assess the economies of scale as well as economies of scope. The empirical studies conducted on SCP relative to the efficient structure hypothesis and relative market power hypothesis indicate that the efficient structure hypothesis is largely related to the organizational efficiency and as such does not necessarily have to comply with the SCP. (Yoshiro, Mitsuhiko, & Hirofumi, 2006). Due to indirect linkage of these two hypotheses with the SCP, both concepts may not be a as good as empirical constructs for conducting empirical studies because of the fact that they neither confirm nor reject the SCP. This fact also, therefore, indicates that the implications of these two hypotheses may be significant on empirical studies conducted. However, both hypotheses may invariably show slightly favorable results than the SCP. As the study by Yoshiro, Mitsuhiko, & Hirofumi confirmed that the Japan’s banks grow more inefficient as they grow in size and capture more market power and concentration. However, efficient structure hypothesis delivers better results as in comparison to the SCP as the empirical studies on The Japanese banking sector indicate that the organizational efficiency supports efficient structure hypothesis and attempts to neglect both the relative market power hypothesis and structure-conduct- performance paradigm in banking. Results and discussion The above review of literature indicates that the various empirical studies have been conducted to understand and correlate the behavior of bank’s performance with the overall structure of the industry. The structure conduct performance paradigm within the banks is a transgression from the theoretical frameworks of industrial economics and basically deal with the assumption of how the firm level performance can be related with the overall industry structure. As mentioned above that the banking sector in a developed world transformed itself into its current form by going through a phases process and each transformation was largely geographical in nature i.e. the banking sector in US developed largely due to the policy implications faced by the different governments first due to great depression and then by implementing the de-regulated environment. Within US, the de-regulation of the banking industry resulted into the culmination of the universal institutions which attempted to offer many services under one roof. Further, the banks in US also resultantly showed a great shift from their assigned roles and brought in structural changes in order to be more efficient. Studies indicate that the role of banks in US developed largely as that of a broker rather than a banker as the established principles of deposit taking and loan making radically changed with the introduction of financial derivatives into the banks. The resultant changes into the structure of the industry and firms however, created a market which was largely fragmented and was considered as competitive. Therefore, the assumption that the large market power or size can result into the collusion by the firms practically failed to be proved. It is also important to note that with consolidation and de-regulation into the industry, customers started to receive better services. However, there are very few studies which can establish the empirical link between the de-regulation and the market concentration. Therefore, it becomes more complicated as to assess whether the improved service to customers is a leading indicator of efficiency or not is still not been proven as a valid empirical possibility. (Jeon & Miller, 2005). Studies from Germany and other EU countries also pointed out this fact that the changes in the structure of the banks do not necessarily lead to efficiency as claimed by the SCP. The universality of banking services does not provide necessary competitive advantage in terms of market share and concentration of power. Numerous studies, however, did indicate that the efficient firms charge lower prices resulting into higher market share and therefore, higher concentration in the market. However, such studies have only taken profitability as a measure of the efficiency and as such failed to take into account the economies of scales and economies of scope to clearly demarcate the efficient firms from inefficient ones. Results from Japanese Banking industry also indicated that the banking performance is largely explained under the efficient structure hypothesis rather than SCP hypothesis. Such indications, therefore, point towards the prospects of using efficient structure hypothesis and relative market power hypothesis as two of the empirical constructs to conduct the empirical studies rather than relying wholly on the SCP as a valid empirical construct for studying the efficiency of banking industry. It is, however, important to note that in order to successfully use efficient structure hypothesis and relative market hypothesis; researchers need to broaden the scope of variables taken to assess the firm level performance. Historically, studies have focused on taking profitability as the measure of efficiency. However, in order to obtain better and more accurate empirical results, it is therefore, critical that the researchers must take other variables such as economies of scale, economies of scope etc into consideration also. Conclusion Structure conduct performance hypothesis is a borrowed concept from industrial economics to understand the correlation between the firm performance and industry structure in banking. Various studies suggested that the SCP does not lead to the correct analysis of the banks’ performance and as such may not be totally relied. However, it is still not correct to conclude that SCP may not lead to obtain correct results. In the nutshell, it is still confusing as to which factor result into increased profitability as the various empirical studies seem to contradict each other. Studies by Jeon and Miller indicate that the higher market power lead to higher profitability within a State. However, studies conducted within a different geographical setting may not be indicating the same results as various other studies have interchangeably proven the superiority of one hypothesis over other. What is, however; unique is the fact that each hypothesis is valid under different economic settings and environment faced by the banks as Banks performance from EU suggest remarkably different results than the banks in US. Bibliography 1. Allen, F., & Carletti, E. (2008). The Roles of Banks in Financial Systems*. In A. Berger, P. Molyneux, & J. Wilson, Oxford Handbook of Banking (pp. 1-30). Oxford: Oxford University Press. . 2. Cetorelli, N. (1999). Competitive Analysis in Banking: Appraisal of the Methodologies. Economic Perspectives , 23, 5-10. 3. Edwards, S., Allen, A. J., & Shaik, S. (2006). Market Structure Conduct Performance (SCP) Hypothesis Revisited using Stochastic Frontier Efficiency Analysis. Retrieved Feb 27, 2009, from http://ageconsearch.umn.edu: http://ageconsearch.umn.edu/bitstream/21350/1/sp06ed01.pdf 4. Fohlin, C. (1995). Banking Industry Structure, Competition, and Performance: Does Universality Matter? . Retrieved Feb 27, 2009, from http://www.hss.caltech.edu: http://citeseerx.ist.psu.edu/viewdoc/summary?doi=10.1.1.26.5501 5. Harris, N. (2000). Business Economics. New York: Butterworth-Heinemann. 6. Hester, D. (2002). U.S. banking in the last fifty years : growth and adaptation. Social Systems Working papers Series 19 , 1-37. 7. Jeon, Y., & Miller, S. M. (2005). Bank Performance: Market Power or Efficient Structure? Retrieved Feb 27, 2009, from http://digitalcommons.uconn.edu: http://digitalcommons.uconn.edu/cgi/viewcontent.cgi?article=1066&context=econ_wpapers 8. Northcott, C. A. (2004). Competition in Banking:A Review of the Literature. Bank of Canada Working Paper 2004-24 , 1-44. 9. Yoshiro, T., Mitsuhiko, S., & Hirofumi, U. (2006). Efficiency Structure Hypothesis versus Structure-Conduct-Performance Hypothesis Revisited. Retrieved Feb 27, 2009, from RIETI: http://www.rieti.go.jp/en/publications/summary/06010000.html Read More