cross-country analysis of the effects of e-banking and financial infrastructure on financial sector competition a schumpeterian shift

Financial services may be entering a period of Schumpeterian competition in which electronic banking and financial infrastructure may fundamentally change the global financial services i

A CROSS-COUNTRY ANALYSIS OF THE EFFECTS OF E-BANKING AND FINANCIAL INFRASTRUCTURE ON FINANCIAL SECTOR COMPETITION:

A SCHUMPETERIAN SHIFT?

By Jennifer Isern

A DISSERTATION

Submitted to

H Wayne Huizenga School of Business and Entrepreneurship

Nova Southeastern University

in partial fulfillment of the requirements

for the degree of

DOCTOR OF BUSINESS ADMINISTRATION

2008

2009

Copyright 2008 by Isern, Jennifer All rights reserved

A Dissertation Entitled

A CROSS-COUNTRY ANALYSIS OF THE EFFECTS OF E-BANKING AND FINANCIAL INFRASTRUCTURE ON FINANCIAL SECTOR COMPETITION:

A SCHUMPETERIAN SHIFT?

By Jennifer Isern

We hereby certify that this Dissertation submitted by Jennifer Isern conforms to

acceptable standards, and as such is fully adequate in scope and quality It is therefore approved as the fulfillment of the Dissertation requirements for the Degree of Doctor of Business Administration

Associate Dean of Internal Affairs

Executive Associate Dean,

H Wayne Huizenga School of Business and Entrepreneurship

Nova Southeastern University

2008

CERTIFICATION STATEMENT

I hereby certify that this paper constitutes my own product, that where the language of

others is set forth, quotation marks so indicate, and appropriate credit is given where I

have used the language, ideas, expressions or writings of another

Signed _

Jennifer Isern

New forces are taking hold in the financial services industry that may change existing competition paradigms Electronic banking is thriving in Japan, Europe, South Africa, the Philippines, and the US as clients click their mouse, press telephone keys, and slide cards to conduct their banking In parallel, credit registries reduce information

asymmetry and contribute to lower costs and increased lending volume Increasingly, banks and other financial service providers are starting to launch many of these same innovations in developing countries Emerging markets are in the position of developing financial infrastructure that could leapfrog those in established markets and provide a broader range of financial services for clients Financial services may be entering a period of Schumpeterian competition in which electronic banking and financial

infrastructure may fundamentally change the global financial services industry

To identify the cross-country determinants of competition, panel data on 1,514 banks was gathered from the BankScope database of financial statements for 2004-2006 for a range

of banks from 185 countries Applying the Panzar and Rosse (1987) model for

competition, this study determined the effect of e-banking and financial infrastructure on bank competition Other classic factors of competition such as country-level factors, financial sector policy, and client factors were also analyzed The research findings include a positive relationship between the level of financial infrastructure and the level

of competition and a negative relationship between the degree of state ownership in a banking sector and the level of competition This study helps to extend competition theory to include electronic banking and financial infrastructure

Keywords: banking, competition, electronic banking, financial infrastructure, credit registries, payment systems, financial services, financial sector development

of the issues and research findings

The Staff and Faculty of the Doctoral Program have given me wonderful assistance and encouragement throughout my classes and dissertation research

I would like to thank those dear souls who kept me afloat with their love, support,

enthusiasm, and patience throughout this endeavor I am grateful to Elizabeth, Mom, Lori, Pam, Brian, Doug, and many more family, friends, and colleagues

Finally, I offer my heartfelt gratitude to my mother, father, grandmother and grandfather, who shared their love of reading and learning with me from my earliest memories In their own special ways, they each showed me that education and lifelong learning truly is the key to the future

Measuring competition and concentration 16 Mitigating factors for competition 18

Factors influencing the adoption of e-banking 46

Client service 61

Conclusion 62

3 METHODOLOGY 65

Introduction 65

Research question 65

Hypotheses 65

Research design 68

Variables and sources of data 70

Dependent variable 70

Independent variables 70

Data collection 78

Data coding 79

Population 79

Data analysis 80

Analytical and statistical techniques 80

Treatments 80

Analysis 80

Assumptions and limitations 83

Conclusion 85

4 ANALYSIS AND FINDINGS 87

Introduction 87

Presentation of the data 87

Descriptive statistics 89

H-statistic 89

Market equilibrium statistic 93

Determinants of competition indicators 96

Results of hypothesis testing 99

Hypothesis 1 100

Hypothesis 2 101

Hypothesis 3 102

Hypothesis 4 103

Hypothesis 5 103

Hypothesis 6 104

Summary of hypothesis testing 105

Conclusion 106

5 SUMMARY AND CONCLUSIONS 107

Overview of significant findings 107

Implications of this study to current theory in the discipline 109 Limitations of this study 110

Implications of the findings for market players 113

Recommendations for future research 114

APPENDICES

3 H-statistics of banking system for selected countries 124

4 Market equilibrium statistics of banking system for selected countries 132

LIST OF TABLES Table

2 Bank and retailer costs per payment transaction 58

3 Description and definition of financial service provider variables and

4 Description and definition of country-level variables and data sources 72

5 Description and definition of variables and data sources to calculate

6 Regression results: Cross-country determinants of H-statistic 97

7 Summary of hypotheses, testing and statistical technique 105

8 Variable frequencies to calculate the H-statistic 117

9 Variable frequencies to calculate the market equilibrium statistic 117

10 Correlation matrix for variables to calculate the H-statistic 119

11 Correlation matrix for variables to calculate the market equilibrium statistic 120

12 Correlation matrix for cross-country determinants of competition 121

13 H-statistics of banking systems for selected countries 125

14 Countries where H-statistic is not significantly different from zero 129

15 Countries where H-statistic is not significantly different from one 130

16 Market equilibrium statistics of banking systems for selected countries 133

17 Distribution of variables for cross-country determinants of competition 138

18 Skewness, kurtosis and Kolmogorov-Smirnov test for cross-country

LIST OF FIGURES Figure

1 Evolution in the US Non-Cash Payment Activity, 2000-2003 37

2 Number of Non-Cash Payments Per Capita, Selected Economies, 2003 38

3 Marginal Cost of Transactions in the United States, by Mode of Delivery 57

CHAPTER 1 INTRODUCTION

Introduction This research analyzed the dynamics of competition in the financial services industry and theories of competition that explain sometimes counter-intuitive effects observed over the last fifty years Specifically, the research addressed the following question: How does electronic banking and financial infrastructure influence competition

in the financial services industry?

New forces are taking hold in the financial services industry that may change existing competition paradigms Electronic banking is thriving in Japan, Europe, South Africa, the Philippines, and the US as clients click their mouse, press telephone keys, and slide cards to conduct their banking In parallel, credit registries are helping to reduce information asymmetry and contribute to lower costs and increased lending volume Increasingly, banks and other financial service providers are starting to launch many of these same innovations in developing countries

Emerging markets are in the position of developing a financial infrastructure that could leapfrog those in established markets to provide a broader range of financial

services for clients The 2007 sub-prime mortgage crisis in the US and spillover effects across financial markets globally in 2007-2008 may cause banks to change strategies that could accelerate adoption of more efficient techniques such as electronic banking, credit registries, and payment services In sum, financial services may be entering a period of

Schumpeterian competition (Schumpeter, 1942) in which electronic banking and

financial infrastructure may fundamentally change the global financial services industry

This chapter begins by summarizing the role of the financial sector in national economic development, competitive issues in financial services, and the potential role of electronic banking in changing competitive forces The second section provides an outline for the study, including sample selection procedures, hypotheses and research design

Background Banks and other regulated financial services providers play a key role in a

country’s economic development (Cameron, 1967; Stiglitz & Weiss, 1981; Levine, 2004; Levine, Loayza & Beck, 2000; Demirguc-Kunt & Levine, 2001) Given its strategic importance, policy makers, researchers and the private sector all need to understand the complex dynamics that affect the financial sector

Within an existing regulatory environment and given national government control

of inflation and monetary policy, competition and concentration determine bank behavior and the countenance of appropriate risk levels Bank concentration and competition, both core elements of market structure, are key drivers affecting financial sector performance (Chandler, 1938; Berger & Hannan, 1989; Allen & Gale, 2000, 2004; Claessens &

Laeven, 2004; Berger, Demirguc-Kunt, Levine & Haubrich, 2004)

The Panzar and Rosse (1987) model explored competition by analyzing the elasticity of bank profit to the bank’s input prices In a perfectly competitive market, an increase in input costs results in an equal increase in both marginal cost and marginal revenue However, in a monopolistic market, an increase in input costs results in

increased marginal costs, decreased output, and decreased total revenue The Panzar and Rosse model has been applied extensively to banking markets in the United States, Canada, Europe, Japan, and an increasing number of regions and countries (Shaffer, 1982; Molyneux, Thornton & Lloyd-Williams, 1996; Bikker & Haaf, 2002; Gelos & Roldos, 2002; Yildirim & Philippatos, 2003; Claessens & Laeven, 2004; Drakos & Konstantinou, 2005; Staikouras & Koutsomanoli-Fillipaki, 2006) Researchers have analyzed the effects of market structure, financial infrastructure, authorized scope of financial services, foreign ownership, and geographic concentration on bank

concentration and competition, as discussed in Chapter 2

Purpose and Justification of the Study This study contributes to financial sector research and policy by investigating the effect of electronic banking and financial infrastructure on financial sector competition across selected developed and developing countries

The implementation of e-banking has the potential to affect the economic growth rate of developing countries if it significantly enhances efficiency and extends the reach

of financial services Evidence is accumulating that e-banking and payments

infrastructure are reshaping the structure and nature of the financial services industry (Isern, 2007; Isern, Donges & Smith, 2006; Allen, McAndrews & Strahan, 2002; Nsouli

& Schaechter, 2002; Claessens, Glaessner & Klingebiel, 2002) By reducing information asymmetry, credit registries can increase competition among banks, reduce interest rates, and increase lending volume (Djankov, McLiesh & Shleifer, 2007; Bátiz-Lazo, 2004; Love & Mylenko, 2003; Miller, 2003; Padilla & Pagano, 1997; Vercammen, 1995)

The adoption of e-banking and other financial infrastructure could greatly lower the cost of financial services and provide substantially greater access to firms and

individuals By increasing efficiency of operations, e-banking can increase economies of scale that could lead to greater consolidation of the financial services industry (Allen et al., 2002) Given these findings and the ongoing evolution in the industry, it seems likely that new services, new delivery channels, and new or hybrid institutions competing for clients will significantly change the financial services industry

The financial services industry may be entering a period of Schumpeterian

competition (Schumpeter, 1942) and creative destruction where innovations may

radically change the nature of competition Under these conditions, inventive new firms gain market power while older, more established firms must change or fade away if they cannot compete effectively in the new market realities

The 2007 downturn in US sub-prime mortgages and special purpose vehicles has developed into a broader financial crisis Weak performance in other financial services includes credit cards, car loans, and leveraged buy-out loans The financial crisis has spread beyond the US with strong ripple effects in Europe, Asia, and other regions Often in financial crises, financial service providers retreat to quality and adopt more conservative strategies One scenario is that banks scale back expansion or capital investment plans, thereby reducing investments in new banking technologies However, banks may also seek greater operating efficiencies, fewer physical branch offices, and diversified clientele facilitated by electronic banking, credit registries, and payments platforms

E-banking and payment systems may have surprising effects on competition in the financial sector, including costs and economies of scale, new entrants and institutional competition, and customer demand for higher service quality E-banking can

substantially increase the number of transactions and clients that a firm can manage, and this leads to efficiency gains (Humphrey & Pulley, 1998) E-banking allows banks and other financial service providers to offer clients another service, and one that may

increase customer loyalty (Mullaney & Little, 2002; Turban, Lee, King & Chung, 2000) Customer loyalty will significantly affect a company’s bottom line through increased sales, lower marketing costs, and lower customer turnover (Turban et al., 2000) Clients are increasingly demanding more services and cost efficiency, and they have greater access to information to compare companies via the internet and other avenues for

marketing

Similar progress is seen in credit registries, with implications for reduced costs new entrants, and greater institutional competition A growing number of data sources are providing information to credit registries, and alternative data such as rent, utilities payments and mobile phone bills may lead to significantly greater coverage of the

population (Turner & Varghese, 2007; Turner, Lee, Schnare, Varghese & Walker, 2006)

Further, so-called ‘unbanked’ clients, or those with no bank account, are using banking technologies such as prepaid cards, and this may be one step towards bringing such clients into the financial mainstream (Anguelov, Hilgert & Hogarth, 2004; Isern et al., 2006; Isern, 2007) In developing countries, e-banking and credit registries may be cost-effective approaches for expanding financial services to the large market potential of people who are currently unbanked

e-Research Outline This research addressed the following question: How do electronic banking and financial infrastructure influence competition in the financial services industry? The research included classic factors of competition such as institutional size, ownership, products, client socio-economic factors, regulation and national development These classic competition factors were analyzed using new lenses of e-banking and financial infrastructure

Problem Statement

Several studies have analyzed competition in the banking sector However no empirical research has applied these theories to the effects of electronic banking and financial infrastructure on financial sector competition

monopolist’s reduced form revenue equation cannot be positive Intuitively, the test statistic, a measure of competition (ψ –statistic or H-statistic), indicates the percentage

1 If this market equilibrium assumption is considered problematic for the model and dissertation, it may be possible to check whether market equilibrium exists for the countries studied For example, one could test whether ROA is statistically significantly correlated with input prices since in equilibrium, they should not

be correlated (Hauner & Peiris, 2005)

change in the bank’s equilibrium revenue resulting from a one-percent increase in all factor prices Increased factor prices shift up all cost curves, including average costs, total costs and marginal costs As a result, the monopolist charges higher prices and the quantity decreases

Based on the relationship between the bank’s factor prices and total bank revenue, and assuming market equilibrium, the Panzar and Rosse (1987) model offers a measure

of competition (ψ –statistic or H-statistic) Where the H-statistic is less than or equal to zero, the market is a monopoly or collusion (joint monopoly) An H-statistic between zero and one indicates monopolistic competition, and where the H-statistic is one, the market is perfectly competitive When using this model, other factors can be analyzed including bank-specific characteristics such as size, ownership, and outreach and level of e-banking and national financial infrastructure Additional details on this model are provided in Chapter 3

Variables included bank revenue, a range of costs, branch infrastructure, level of country economic development, disparity of national income, concentration of the

financial sector, level of e-banking, national financial sector policy, coverage of credit registries, national financial and telecommunications infrastructure, and client factors such as education and income levels A broad sample of countries was selected across regions, country income level, and stage of development of e-banking and financial infrastructure The research used publicly available data from several renowned sources

of information on banks and country development such as BankScope, the World Bank, the Bank for International Settlements, and the United Nations Variables and their corresponding sources of data are reviewed in detail in Chapter 3

Conclusion The financial sector carries strategic importance for national and international economic stability and development Of the many measures of financial sector health, competition is one of the more complex factors to analyze Given rapid technological advances, electronic banking and financial infrastructure may fundamentally change the financial services industry at a global and national level This research investigated the factors that affect banking competition globally and extend existing research to

incorporate the effects of e-banking and financial infrastructure

CHAPTER 2 LITERATURE REVIEW

Introduction The health of the financial services industry affects the economy of a country at many levels including individuals, households, firms, and overall national development (Cameron, 1967; Stiglitz & Weiss, 1981; Levine, 2004; Levine, Loayza & Beck, 2000; Demirguc-Kunt & Levine, 2001) Therefore an important strategic element of national policy is the development of a sound and vibrant financial services sector Globally, the financial services sector is clearly seeing inroads from new technologies that facilitate e-banking and electronic money opportunities (Isern, Deshpande & van Doorn, 2005; Isern, Donges & Smith, 2006; Isern, 2007)

E-banking through automated teller machines (ATMs), points of service card readers, the internet, and mobile phones using modern payment infrastructure is well established in several developed markets Credit registries have become core

components of the financial infrastructure and bank lending methodology in many

markets (IFC, 2006; Miller, 2003; Mylenko and Love, 2003) Increasingly, these

technologies are being introduced in other countries at varied stages of economic and financial sector development As emerging markets develop infrastructure, advances in e-banking, payment infrastructure and credit registries are opening new opportunities for the financial sector A key question is whether e-banking and payment infrastructure provide purely new delivery channels for established financial products or whether they have the potential to shift the competitive landscape for financial services firms

Likewise, the potential efficiency and outreach gains of credit registries have not yet been exploited across all client segments and services

This chapter begins by reviewing the role of the financial sector in national

economic development Section two explores leading theories and empirical analysis of banking concentration and competition and factors that influence competition Section three summarizes e-banking and credit registries, relevant experience in developed and emerging markets, and factors influencing the adoption of e-banking and credit registries Section four reviews effects to date of e-banking and credit registries on efficiency and competition in financial services Section five concludes

The Role of the Financial Sector Banks and other regulated financial service providers mobilize deposits, allocate credit, process money transfers, and provide other related services The health of the financial services industry affects the economy at many levels including individuals, firms, and overall national development (Demirguc-Kunt & Levine, 2008; Levine, 2004; Levine, Loayza & Beck, 2000)

Given the financial sector’s importance to a country’s economy, national and international policy makers, researchers, and the private sector devote considerable

attention to measuring and ensuring the health of the financial services industry

Evidence for the relationship of financial sector development with positive economic growth is consistently supported by empirical research (Demirguc-Kunt & Levine, 2008; Beck, Demirguc-Kunt, Levine & Maksimovic, 2001; Sauvé & Gillespie, 2000;

Goldsmith, 1969)

Historically, many governments in developing countries have neglected the financial sector’s potential contribution to economic growth (Berthelemy & Varoudakis, 1996) and fledgling banking systems were seen as monetary means to achieve the

government's development objectives Consistent with this conception, many of these same governments actively repressed financial institution growth by imposing

inordinately high reserve requirements (often in the form of central bank deposits) while directing the flow of bank capital toward favored projects (Bandiera, Caprio, Honohan & Schiantarelli, 2000)

During this time, many banks, including second-tier development banks for agriculture, industry or other areas of the economy, in developing countries were state owned (Berthelemy & Varoudakis, 1996) These development banks borrowed from multilateral, regional and bilateral donors and frequently on a subsidized basis As the shortcomings of this approach became increasingly apparent, some developing country governments reversed course by initiating financial liberalization programs beginning in the late 1980s as a means for stimulating higher levels of private savings and, hence, economic growth

Leading measures of the health of the financial services sector include market structure, client access to services, market efficiency, market profitability, and stability (World Bank, 2005) Each of these measures interacts with the others, and analyzing them as a group provides the most useful analysis For example, market structure as measured by competition has complex effects on market stability Allen and Gale (2004) argue that increased competition may lead to short-term efficiency, but it may lead to greater instability for the banking system and negative consequences for national

economic development Further, offering services to a broad range of clients may affect

a bank’s long-term efficiency and profitability in sometimes surprising ways (Isern & Porteous, 2005) Banking regulation and supervision also influence bank performance, market development, and financial sector stability (Barth, Caprio & Levine, 2004)

Banks are inherently risky since they mobilize public deposits (often short-term) and then lend (often long-term) to individuals, firms, and others (De Ceuster &

Masschelein, 2003; Fama, 1980; Baltensperger & Dermine, 1991; Boot, Dezelan & Milbourn, 2000) Banks must constantly manage their liquidity, the quality of their loan portfolio, and the reserves on hand to cover deposit withdrawals Further, banks are caught in a web of asymmetric information concerning both borrowers and depositors, which may lead to adverse selection and/or moral hazard that negatively affects the bank’s lending portfolio (Guzman, 2000) Conversely, depositors rarely understand the financial health of their bank, and are vulnerable to bank failure and loss

Negative financial sector effects strongly affect market economies, particularly in emerging countries, and these effects may well spread to countries with more robust economies Bank failures can be initiated by a range of factors including weak bank management, uncontrolled growth, corruption, loss of depositor confidence, and/or macroeconomic shocks Bank failures are more damaging to the economy than failures

of other types of firms of similar size since one bank’s problems can spread like a

contagion throughout the financial sector and mushroom into systematic poor

management of banks, poor and non-independent supervision by national authorities, and broad financial and economic instability (Kaufman & Seelig, 2000; Claessens, Djankov

& Klingebiel, 1999) Countries experiencing bank failures that eventually cascaded into

national macroeconomic shocks include Mexico in the 1995 Tequila Crisis, Indonesia and Korea in the late 1990s, and Turkey in the late 1990s (Claessens et al., 1999;

Harwood, Litan & Pomerleano, 1999)

Inversely, a macroeconomic shock can create instability simultaneously in a large number of financial institutions and increase systemic risk (De Ceuster & Masschelein, 2003) Examples of national macroeconomic shocks that devastated financial institutions include Russia in 1998, Argentina in 2001, the East Asia crisis in 1997-1999, Turkey in 2001-2002, and Japan in the late 1990s (Claessens et al., 1999; Harwood et al., 1999)

Financial crises are linked with macroeconomic distress such as increases in inflation and unemployment, deeper poverty, and greater income inequality (Baldacci, de Mello & Inchauste, 2002) Longer term, financial crises can also force changes that improve the sector such as more effective bank supervision, restructuring, merger or closure of poorly performing banks, and modernization of banking management and services (Barth, Caprio & Levine, 2004; Claessens, Glaessner & Klingebiel, 2001)

Given the unique role and risks of the financial sector, special attention and regulation is arguably required to prevent bank failure (Fama, 1980; Baltensperger & Dermine, 1991) The level of enforcement and supervision of banking regulations

influences individual bank performance, market development, and overall financial sector stability (Barth et al., 2004) However, poorly designed regulation can create distortions

in the financial sector and negatively affect competition among financial sector firms (Boot, Dezelan & Milbourn, 2000) For example, more stringent regulation can lead to higher costs for clients if the presence of fewer financial institutions leads to the industry becoming less competitive In a counter-intuitive twist, tighter regulation may actually

lead to more competition and lower interest rate spreads despite a more concentrated market (Schargrodsy & Sturzenegger, 2000) Overall, caution is needed since regulation that limits competition can lead to greater banking system fragility (Beck, Demirguc-Kunt & Levine, 2006)

Financial liberalization typically entails both increased deposit/lending interest rates and an expansion in consumer credit Loayza et al (2000) found that higher real interest rates and larger domestic credit flows had a negative effect on private savings rates More specifically, these researchers calculated that a 1 percent increase in real interest rates was associated with a private savings rate decline of approximately 0.25 percent in the short term, while a 1 percent rise in private credit (relative to aggregate private income) reduced private savings by 0.32 percent In the near term, these two salient dimensions of financial liberalization were characterized as being "largely

detrimental to private savings rates" (Loayza et al., 2000, p.180) This study concludes that financial liberalization led to borrowing increasing at a significantly faster past than private savings

Nevertheless, Loayza et al (2000) suggested that in the long term, financial liberalization is likely to boost private savings rates As Bandiera et al (2000) asserted,

"once it has settled down, a competitive, liberalized financial system will typically be characterized by improved savings opportunities, including higher deposit interest rates, a wider range of savings media with improved risk-return characteristics, and in many cases, more banks and bank branches, as well as other financial intermediaries" (p.240)

If financial liberalization leads to the more efficient allocation of capital resources (as it should over time), "this will generate increases in income that will in turn increase

savings" (Bandiera et al., 2000, p.240) Liberalization combined with advances in

banking technology can be a significant factor to increase bank competition and reduce costs to clients (Vesala, 2000) Under these favorable circumstances, liberalization may

be a key measure to create a self-reinforcing pattern of economic growth

Market structure and competitive forces are changing as deregulation allows broader scope of services, geographic operations, and mergers at the national and

international level In parallel, new technologies in back-office systems and front-office interactions with clients are increasing efficiency and opening new frontiers in financial services The next section turns to an examination of concentration and competition in the banking industry overall

Concentration and Competition Within an existing regulatory environment and given national government control

of inflation and monetary policy, competition and concentration determine bank behavior and the countenance of appropriate risk levels Bank concentration and competition, both core elements of market structure, are key drivers affecting financial sector performance (Chandler, 1938; Berger & Hannan, 1989; Allen & Gale, 2000, 2004; Martinez-Perez & Mody, 2004; Claessens & Laeven, 2004; Berger, Demirguc-Kunt, Levine & Haubrich, 2004; Isern & Clarke, 2007) Competition is defined as a market structure that consists

of a large number of perfectly knowledgeable buyers and sellers who are individually too small to affect the market price and who engage in the exchange of a homogeneous good (Park, 1998) As defined by the general equilibrium model (Bresnahan, 1982), in a perfectly competitive market an increase in input costs results in an equal increase in both

marginal cost and marginal revenue Concentration measures the density of the banking industry by the number of firms present in the market

Measuring Competition and Concentration

The structure-conduct-performance (SCP) framework is one of the leading

theories used to analyze banking competition and concentration Originally developed

by Bain (1956) to test the effects of market concentration and barriers to entry in United States manufacturing, the SCP framework has been widely applied to the banking

industry globally Bain posited that structural factors in the market such as concentration and barriers to entry influence a firm’s conduct, and this impacts the firm’s profitability

Two main subsets of the SCP paradigm are first the structure-performance

relationship which tests for non-competitive behavior to establish the drivers of firm profitability (Berger & Hannan, 1989; Hannan, 1997; Neumark & Sharpe, 1992;

Okeahalam, 2004), and secondly the efficient structure relationship which posits that concentrated markets may be more profitable given economies of scale resulting from greater efficiency of larger firms (Berger, 1995; Keasey & Watson, 1995) Banking studies based on the SCP framework typically seek to test both the SPH and ESH for reliability The SPH is more widely supported by studies of the banking sector (Berger

& Hannan, 1989; Hannan, 1997; Neumark & Sharpe, 1992; Okeahalam, 2004)

However, other studies confirm the ESH (Berger, 1995; Keasey & Watson, 1995) Efficiency of operations is suggested as more important than market concentration to explain bank profitability (Berger & Humphrey, 1992)

Bresnahan (1982, 1989) developed another approach to analyzing market

competition that has been widely applied to the financial services industry Bresnahan’s

model is founded on the general market equilibrium where profit-maximizing firms set the price and quantity of their services so that marginal costs equal their perceived

marginal revenue (Bresnahan, 1982, 1989) The firm’s choice of price and quantity match the price demanded by clients in a perfectly competitive market Or, in a perfectly collusive market, the firm’s choice of price matches the industry’s marginal revenue Shaffer (1989) pioneered the application of the Bresnahan model to the financial services industry based on data from the United States and strongly rejected collusion but not perfect competition Neven and Roller (1999) analyzed six European countries for the period 1981-1989 and found collusive behavior Shaffer (2001) applied the Bresnahan model to a sample of fifteen countries in Asia, Europe and North America using data from 1979-1991 and identified significant market power in five countries

The Herfindahl-Hirschman index is another measure of competition across

industries calculated on the basis of each firm’s individual market share Wong and Wong (2001) applied this model to China’s banking industry and report an oligopolistic market dominated by the four largest state banks

A fourth approach builds on industrial organization theory developed by Panzar and Rosse (1977, 1987) to measure financial sector competition The Panzar and Rosse (1987) model explored competition by analyzing the elasticity of bank profit to the bank’s input prices In a perfectly competitive market, an increase in input costs results

in an equal increase in both marginal cost and marginal revenue However, in a

monopolistic market, an increase in input costs results in increased marginal costs, decreased output, and decreased total revenue

The Panzar and Rosse (1987) model has been applied extensively to banking markets in the United States, Canada, Europe, Japan, and an increasing number of

regions and countries Shaffer (1982) first applied an earlier Panzar and Rosse concept

of competition analysis to a sample of banks in New York and reported monopolistic competition Molyneux, Thornton, and Lloyd-Williams (1996) applied the model to the Japanese banking industry for the period 1986-1988 and reported a monopolistic market Bikker and Haaf (2002) noted monopolistic competition in European and OECD

countries, while Staikouras and Koutsomanoli-Fillipaki (2006) confirmed monopolistic competition in the enlarged European Union and compared the ten new EU member states with the older EU member states Gelos and Roldos (2002) analyzed the markets

of eight developing countries in Latin America and Europe and reported that markets remained competitive during the 1990s despite significant structural changes Mixed markets with neither perfect competition nor monopoly are identified in Central and Eastern Europe (Yildirim & Philippatos, 2003; Drakos & Konstantinou, 2005) Applying the model to a sample of fifty diverse countries, Claessens and Laeven (2004) concluded that more concentrated banking systems are more competitive

Mitigating Factors for Competition

The potential for pure competition is equivocal in the banking industry given that deposits and loan products can be tailored to individual clients (Chandler, 1938)

Perceived high switching costs in terms of time, loss of privacy and control over financial information (Allen & Gale, 2000), and low levels of financial literacy may prevent a client from seeking or effectively comparing other financial service providers

Restrictions such as geographic limits on new branches still limit banking competition in many markets (Chandler, 1938)

Evidence for a consistent link between concentration and competition is

ambiguous Concentration may not imply reduced competition (Gruben & McComb, 2003; Shaffer, 1993) nor does heterogeneity imply increased competition (Winton, 1997) More concentrated markets are associated with lower probability of a banking crisis, and

as a system matures and consolidates, it becomes less fragile (Winton, 1997; Beck,

Demirguc-Kunt & Levine, 2003, 2006) Stronger performance is associated with

industry concentration (Hughes, Lang, Mester & Moon, 1999; Allen & Gale, 2004), but depending on the measure of risk and instability, concentration has been linked to both higher risk (Hughes et al., 1999) and lower risk (De Nicolo, Bartholomew, Zaman & Zephirin, 2004)

Bank monopolies are associated with negative or ambiguous effects (Cetoreilli, 1997) and positive effects (Schnitzer, 1998) on the economy For example, banks with significant market power, as in a monopoly situation, may require greater collateral for loans, and this could lead to credit rationing (Hyman, 1971; Hainz, 2003) Both

Cetoreilli (1997) and Schnitzer (1998) suggest that monopoly banks conduct better due diligence of their clients and can overcome some information asymmetries Competition may lower bank profits, push banks to take more risks in lending, increase the effects of adverse selection by banks, and contribute to lower quality of a bank’s lending portfolio (Broecker, 1990; Nakamura, 1993; Riordan, 1993; Shaffer, 1998; Marquez, 2002)

In contrast, Koskela and Stenbacka (2000) suggest that competition lowers

lending rates and increases investment without reducing the bank’s lending portfolio

quality But in some cases of super competition banks operate at levels where marginal cost exceeds marginal revenue to gain market share and engage in risky behavior

(Shaffer, 1993; Gruben & McComb, 2003) In a less competitive market, banks would adopt riskier behavior and could be expected to increase their lending rates and decrease their deposit rates (Boyd & De Nicolo, 2005) Thus, bank concentration may lead to lower levels of financing depending on the country context, especially for markets with low institutional and economic development (Demirguc-Kunt, Laeven & Levine, 2004; Beck, Demirguc-Kunt & Maksimovic, 2004)

Researchers have analyzed the effects of market structure, financial infrastructure, authorized scope of financial services, foreign ownership, and geographic concentration

on bank concentration and competition, as discussed in the following section

Market Structure

Several scholars have analyzed the strengths and weaknesses of bank-based and market-based financial systems When the bank-based countries of Japan and Germany achieved higher growth rates than the United States and the United Kingdom in the 1980s, scholars tended to see their type of financial structures as the superior form In the 1990s, however, this tendency underwent a dramatic reversal: the market-based financial structure in the US and the UK demonstrated higher output growth rates (Allen & Gale, 2000) Bank-based financial systems are generally associated with more regular access to capital and are viewed as a superior means for providing staged financing to

enterprises/projects over time (Stulz, 2001) However, banks are traditionally more risk averse and less willing to finance innovative undertakings, including firm start-ups, than equity and venture capital markets (Demirguc-Kunt & Levine, 2001)

Both banking institutions and equity markets furnish a range of financial services

to investors and clients that are critical for individual and household asset management, firm creation, enterprise expansion, and economic growth The majority of recent studies strongly suggest that neither type of national financial structure is inherently superior to its counterpart (Demirguc-Kunt & Levine, 2001; Beck, Demirguc-Kunt, Levine &

Maksimovic, 2001; Beck & Levine, 2000; La Porta, Lopez-de-Silanes, Shlefer & Vishny, 1998; Levine, 2000; Stulz, 2001) Demirguc-Kunt and Levine (2001) noted that several recent studies are "astonishingly consistent” in their conclusions that "no evidence exists that distinguishing country performance by financial structure helps explain differences

in economic performance" (p.8)

Beck et al (2001) test the explanatory power of four perspectives on the

relationship between financial structure and economic performance: (1) the bank-based view, (2) the market-based view, (3) a law and finance view, and (4) a financial services view In this work the suppositions of the law and finance view and the financial services view show more validity than either the bank- or market-based perspectives (Beck et al., 2001) The law and finance view suggests that the relationship between a country's

financial system and its economic growth and development is contingent on the presence

of a legal system that protects equity and bond investors The relevant attributes of each country’s legal system, including protection of private property rights, the regulatory system, and contract enforcement provide the framework within which capital is

mobilized and allocated by banks and/or by financial markets (La Porta,

Lopez-de-Silanes, Shlefer & Vishny, 1998)

The congruent financial services perspective argues that both banking institutions and equity markets furnish a range of services to investors and clients that are critical for firm creation, enterprise expansion, and economic growth (Beck et al., 2001) From this standpoint, the range and accessibility of services offered by banks or markets or (ideally) both provides the highest explanatory or predictive power for economic growth and development Allen and Gale (2000) reached a similar conclusion that the optimal

financial structure is a hybrid mix of banks and markets offering the broadest and most competitive services to the highest proportion of firms and individuals

Payment Systems

Given more integrated financial markets and new technology, payment systems are increasingly vital to the health and growth of the financial sector (Isern, Donges & Smith, 2006; BIS, 2005; Rochet & Tirole, 1996; Flannery & Kaufman, 1996) Payment systems include the institutions, payment instruments, rules and procedures, payment standards and technology required to exchange monetary value (Isern et al., 2006) For payment systems to work efficiently, banks and other financial intermediaries who

normally compete for clients must work together to ensure efficient payment transactions (Chakravorti & Roson, 2005; Kemppainen, 2003) For e-banking and e-money to

succeed, agreement is needed on the parameters of the payment system, including access

to the payments system and consequent adoption by banks, other financial institutions, merchants, and other retailers Payment system regulators should provide a level playing field among the payments providers, although this is not always the case globally (BIS, 2007; Isern, Donges & Smith, 2006; Chakravorti & Roson, 2005) International

principles on payment systems encourage the development of secure and efficient

payments by transparent and accessible firms operating in competitive markets (BIS, 2007; BIS 2005)

Banks and other financial services firms must cooperate to ensure a operating financial infrastructure based on inter-operable systems Merchants commonly pay a commission to process bankcard payments for credit and debit cards using such well-known brands as Visa, MasterCard, and others Given the perceived high

smoothly-processing costs, merchants in the US are already exploring their own alternatives such as stored-value cards and prepaid cards (Bézard, 2005) Likewise, banks,

telecommunications firms, and payment providers are teaming up for new business models, as discussed later in the section on e-banking

Credit Registries

By reducing information asymmetry, credit registries can increase competition among banks, reduce interest rates, and increase lending volume (Djankov, McLiesh & Shleifer, 2007; McDonald & Schumacher, 2007; Sorge & Zhang, 2007; Bátiz-Lazo, 2004; Padilla & Pagano, 1997; Vercammen, 1995).2 Credit registries are categorized depending on their ownership (public vs private), the type of credit information collected (negative-only vs full file), the type of client (consumer vs commercial) and participants providing information (Turner & Varghese, 2007; IFC, 2006)

Credit registries provide information on client financial history, and this enables firms to perform background checks that facilitate opening accounts and providing other

2 The term credit registry is used throughout the analysis Unless specified in the text, this broad term encompasses a range of credit registries and/or credit bureaus including commercial and consumer, public and private, positive and negative, and full and fragmented credit bureaus The analysis does not include collateral registries, used for both commercial and consumer credit For commercial credit, collateral registries include descriptive information and legal claim to a business’s accounts receivable, inventory, equipment, real estate, and other types of collateral The impact of collateral registries, as yet another component of financial infrastructure, could be considered in future research

financial services Credit registries could provide negative or positive information Negative information reflects missed payments or other problems with the account Positive information records the overall account history including on-time payments Debate continues whether public registries or private registries provide greater benefits (Love & Mylenko, 2003; Miller, 2003)

The range of service providers reporting to a credit bureau is also expanding Fragmented registries cover only a section of credit operations in a country, such as banks or retail credit Full registries include credit operations across a range of providers including banks, retailers, mobile phone operators, utilities, etc Banks were once the primary reporters, although credit registries are opening access to other types of financial service providers and even considering non-financial service firms such as

telecommunications firms, utilities and landlords, and others The use of alternative sources of data may lead to significantly greater coverage of the population (Turner & Varghese, 2007; Turner, Lee, Schnare, Varghese & Walker, 2006) People with no credit

or formal financial obligations have thin or non-existent files on record at a traditional credit bureau However, statistically these people pose no greater credit risk than the average client (Bruno-Britz, 2008) Full credit registries are developing across a growing number of countries, although challenges remain to ensure broad client coverage with timely and accurate information (Turner & Varghese, 2007; IFC, 2006)

Credit registries raise strategic questions for financial service providers (Love & Mylenko, 2003; Hunt, 2005; Miller, 2003) Lenders may be reluctant, at least initially, to share information on their clients with credit registries for fear of losing good clients and aiding their bank competitors (Pagano & Jappelli, 1993) Unless the information is

timely and accurate, financial service firms may question the benefit of contributing information given the cost in time, fees for the credit bureau, and potential risk of sharing information (Hunt, 2005; Miller, 2003) Despite these real challenges, credit bureaus are

an increasingly essential part of the financial infrastructure and have proven effective as tools to expand access to financial services and promote development of the financial sector

Given developments in e-services, payment systems and credit bureaus, financial service providers must weigh competition or collaboration with a new set of actors including retailers, mobile phone companies, and others with potential to launch e-

banking

Authorized Scope of Financial Services

An institution’s ability to offer services is another factor that affects competition

In universal banking, financial institutions are able to hold equity as well as offer loans and other financial services to their clients Germany is one of the most frequently cited examples of universal banking (Buch & Golder, 2000) where institutions are authorized

to provide commercial banking, investment banking, securities, asset management, and insurance Other forms of universal banking, as practiced in Japan, Korea, Turkey and Russia, include financial industrial groups (FIGS) with a bank at the center of a large industrial group (Volchkova, 2001; Perotti & Gelfer (1999) In the United States, the Glass-Steagall Act of 1933 prevented commercial banks from providing equity (Kroszner

& Rajan, 1994) The Glass-Steagall Act was largely viewed as a response to widespread speculation by banks (and many others) and the 1929 stock market crash The Act remained in force until the Gramm-Leach-Bliley Act of 1999 permitted banks to offer a

broader range of services including underwriting and other equity services (Czyrnik & Klein, 2004) This stands in stark contrast to long-standing and widespread universal banking in Europe

In national markets, the range of authorized financial services depends on level of financial sector development, history of crises, and the strategic framework of national regulators Decisions on scope of financial services directly affect concentration and competition in the financial services industry

Universal banking with integrated financial services can provide a greater supply

of higher-quality financial services, lower financial intermediation costs, and lower risks for clients, the financial services institution, and the national economy (Claessens, 2002) Alternatively, universal banking may create powerful entry barriers that constrain market competition (Rajan, 1998), increase regulatory and supervisory challenges, and increase distortions in the market (Boyd, 1999)

Foreign Ownership

The extent of foreign ownership adds another dimension to the analysis of market structure and competition As a part of their financial liberalization programs, several developing country governments have relaxed restrictions on foreign banking activity Various banking crises and privatization efforts in developing countries created

conditions that facilitated foreign bank penetration Examples of banking crises that led

to greater foreign bank penetration within three years include the Mexican Tequila crisis

in 1995, Korea during the East Asian crisis in 1997-1999, and the Turkish crisis in

2001-2002 (Barth, Caprio & Levine, 2004; Claessens, Glaessner & Klingebiel, 2001; Harwood

et al., 1999) During bank privatization in Eastern and Central Europe in the past decade,

virtually all privatized banks in Poland, Hungary, the Czech Republic, Croatia, Romania, Serbia, and Bulgaria were acquired by foreign banks and modernized (Desai, Lieberman

& Nestor, 1997; Pohl, Anderson, Claessens & Djankov, 1997) Not all foreign owned banks do well, however In their cross-country comparison of banks, however, Berger, DeYoung, Genay & Udell (2000), found that domestic banks have higher profit

efficiency than foreign banks

Compared the 1970-90s during the heavy privatization period, foreign ownership

is also changing given more integrated global markets Foreign investors in national bank markets include globally active banks, regional banking groups, and non-bank investors (Domanski, 2005) Each of these investor groups will typically have different strategies and responses to crises, depending on their degree of involvement in the

country and region

Foreign ownership of banks provides mixed evidence of positive effects for clients Foreign ownership can lead to greater competition, increased capitalization, reduced costs, improved lending practices, more efficient service compared to domestic banks (Boubakri, Cosset, Fischer & Guedhami, 2005; Martinez-Peria & Mody, 2004; Huizinga, Claessens & Demirguc-Kunt, 1998), and increased stability of the banking system (Dages, Goldberg & Kinney, 2000) However, privatization and resulting foreign ownership can also lead to closing bank branches or shifting client segments (Beck & Martinez-Peria, 2008; Mukherjee, Nath & Nath Pal, 2002) Cull & Martinez-Peria (2007) argue that foreign ownership is often following crises to acquire distressed banks, and this explains the reduced volume of lending in the short term Mian (2003) argues that private domestic banks tend to lend more aggressively and at higher rates compared

to foreign banks Foreign banks are limited (presumably by their international parent banks) to only lend to ‘hard information’ firms that represent a much smaller potential pool of clients in most developing countries In this case, hard information refers to public information that can be verified by a third party, such as audited financial

statements or loan guarantees In a more recent review of twenty emerging countries from 1989 to 2001, Arena, Reinhart and Vázquez (2007) conclude that foreign banks have a lower sensitivity of credit to national monetary conditions, and that the differences

in lending volume and rates are not strong

Nonetheless, foreign ownership may accelerate the introduction of e-banking services and use of credit registries from experience in other countries Further, foreign banks often have their own established e-banking, credit registry and credit scoring protocols and infrastructure, and potentially greater access to capital needed to upgrade banking technology, systems, and staff training

State Ownership

As part of the inquiry on privatization and foreign ownership, the debate

continues on the role and performance of public sector banks Forty percent of the

world's population lives in countries in which public sector institutions dominate the banking system (Caprio, Fiechter, Pomerleano & Litan, 2005) Public sector banks are often justified for serving a broader range and greater number of clients than foreign banks or private domestic banks (Mukherjee, Nath & Nath Pal, 2002; Saha & Ravisankar, 2000; Sathye, 2001) State banks may benefit from preferential refinancing rates, state guarantees (whether implicit or explicit), government clients and services, and other advantages (Wolgast, 2001; Caprio, Fiechter, Pomerleano & Litan, 2005)

More recent analysis suggests that while foreign and private domestic banks have their respective strengths and weaknesses, public sector banks perform uniformly poorly, are often politicized, and rely on substantial government support to survive (Mian, 2003) Several cross-country studies have concluded that state ownership of banks is greater in countries with less advanced financial systems, lower income levels, and interventionist governments (Caprio, Fiechter, Pomerleano & Litan, 2005; Clarke, Cull & Shirley, 2005;

La Porta, Lopez-De-Silanes & Shleifer, 2002) Higher levels of state-owned banks may lead to greater systemic risk and instability given credit misallocation (Beck, Demirguc-Kunt &Levine, 2003; La Porta, Lopez-de-Silanes and Shleifer, 2002) Nonetheless, state-owned banks can be large, high profile institutions, and policy makers may seek to

salvage them to maintain public confidence (Wolgast, 2001)

Regional and country studies have supported this broader view In Eastern

European banking sectors, foreign-owned banks have been shown to be more efficient than state-owned banks (Desai, Lieberman & Nestor, 1997; Bonin, Hasan & Watchel, 2004) Chen underscores the high level of non-performing loans, estimated as high as 40 percent of outstanding loans, especially among the state-owned banks in China (Chen, 2006) Isik (2007) reports low productivity gains for state-owned banks in Turkey

compared with those for private banks or foreign-owned banks Angur, Nataraajan, and Jahera, (1999) highlight the change towards greater retail service quality and adoption of banking technology in India following privatization of state-owned banks in the late 1990s In their review of Brazilian banking sector, Nakane and Weintraub (2005)

conclude that state-owned banks are less productive than private banks and that

privatization has improved bank productivity, although the positive effects of