The Effects of Regulatory Reform on Competition in the Banking Industry

Article excerpt

IN THE LAST 20 years, European countries have implemented numerous regulatory changes affecting the banking industry, motivated by the need to achieve the level of harmonization required for the establishment of a single, competitive market for financial services. A fundamental step in this process was the implementation, in the early 1990s, of the Second Banking Coordination Directive, which defined the basic conditions for the provision of the so-called Single Banking License. Prior to the enforcement of the new regulation, cross-border expansions were subject to the authorization and subsequent control of the host country, as well as to capital requirements. Under the current regime, in contrast, banks from European Union (EU) countries are allowed to branch freely into other EU countries. It is common opinion that the Second Banking Coordination Directive has represented the most significant deregulation in European banking in recent history. By removing substantial barriers to entry, the new legislation was specifically aimed at generating significant improvements in the competitive conditions of financial markets (Cecchini 1988).

However, during the last decade European banks have also experienced a significant process of consolidation, as indicated by a substantial decrease in their number in many countries (Table 1). (1) In keeping with the structure--conduct--performance hypothesis, one would expect negative effects on competition, especially considering that consolidation has mostly taken place within individual countries--relatively few genuine cross-border bank mergers have been observed in Europe. (2)

Note that the recent wave of mergers can be viewed as the incumbents' response to the potential threat of foreign entry generated by the deregulation. Banks may consolidate in the attempt to reap efficiency gains, which, if realized, would enable them to lower prices, thereby deterring foreign entry and consequently yielding overall pro-competitive effects (see, e.g., Berger et al. 2000). However, it is well known that the empirical evidence about scale economies in banking is inconclusive; the evidence available for Europe suggests that the efficiency gains from consolidation have been relatively small so far (Berger 2000). Thus, consolidation could simply have been driven by the need to grow larger and consequently more difficult to be acquired.

The overall impact of these developments--deregulation and consolidation--on bank competition is therefore a priori ambiguous. The existing literature has in general indicated that competition among European banks has only improved modestly as a result of deregulation. However, this evidence is often anecdotal, or based on qualitative surveys or on cross-country comparisons of aggregate time series data (see, e.g., Economic Research Europe Ltd., 1997, Danthine et al., 1999, and Goddard, Molyneux, and Wilson, 2001). Several studies have performed more sophisticated analyses (see, e.g., Molyneux et al., 1994, Suominen, 1994, Vesala, 1995, De Bandt and Davis, 1999, Coccorese, 1998, Bikker and Groeneveld, 2000, and Bikker and Haaf, 2000); however, in general their focus is not on the timing of changes in competition and on their determinants.

In order to address these issues, in this paper we analyze the Italian banking industry over the 1984-1997 period. We focus on Italy for several reasons. First, the data set at our disposal for that country is unusually rich, comprising balance sheet information on virtually all Italian banks (about 900 on average each year) over a sample period of 14 years. This allows us to identify the local market where each bank conducts most of its business and to perform the investigation at a level of depth typically unattainable by similar studies. Second, the Italian banking system is one of the largest in the EU, ranking third after Germany and France in terms of asset size. Moreover, the previously mentioned consolidation and deregulation processes are not the only common features characterizing the Italian and the other main European banking systems in recent years: reductions in staff costs, an indication of potential efficiency improvement, and an expansion in the branch network have been recorded in several other countries (e. …