Academic journal article
By Claessens, Stijn; Laeven, Luc
Journal of Money, Credit & Banking , Vol. 36, No. 3
COMPETITION IN THE financial sector matters for a number of reasons. As in other industries, the degree of competition in the financial sector can matter for the efficiency of the production of financial services, the quality of financial products, and the degree of innovation in the sector. Specific to the financial sector is the link between competition and stability, long recognized in theoretical and empirical research and, most importantly, in the actual conduct of prudential policy towards banks (Vives 2001). It has also been shown, theoretically as well as empirically, that the degree of competition in the financial sector can matter for the access of firms and households to financial services and external financing, in turn affecting overall economic growth, although not all relationships are clear.
While some relationships between competition and banking system performance and stability have been analyzed in the theoretical literature, empirical research on the issue of competition, particularly cross-country research, is still in an early stage. Data problems were previously a hindrance for the cross-country research since little bank-level data were available outside of the main developed countries; however, recently established databases allow for better empirical work. Another hindrance to the interpretation of existing empirical work has been that a number of theoretical issues are not taken into account. The long-existing theory of industrial organization has shown that the competitiveness of an industry cannot be measured by market structure indicators alone, such as number of institutions, or Herfindahl and other concentration indexes (Baumol, Panzar, and Willig 1982). The threat of entry can be a more important determinant of the behavior of market participants (Besanko and Thakor 1992). Theory also suggests that performance measures, such as the size of the banking margins or profitability, do not necessarily indicate the competitiveness of a banking system. These measures are influenced by a number of factors, such as a country's macroperformance and stability, the form and degree of taxation of financial intermediation, the quality of the country's information and judicial systems, and bank-specific factors, such as scale of operations and risk preferences. As such, these measures can be poor indicators of the degree of competition.
Rather, testing for the degree of effective competition requires a structural, contestability approach, along the lines pursued in much of the industrial organization literature. As in other sectors, the degree of competition in the banking system should be measured with respect to the actual behavior of (marginal) bank conduct. The actual behavior should be related not only to banking market structure but also to entry barriers, including barriers on foreign ownership, and the severity of activity restrictions since those can limit the degree of intraindustry competition. Furthermore, the degree of competition from other forms of financial intermediation (capital markets, nonbank financial institutions, insurance companies) will play a role in determining banking system competitiveness. To date, however, few cross-country tests have taken this approach.
These considerations suggest some advantages of using a more structural approach to assess the degree of competition in the financial sector. While one cannot expect to address all issues, a more formal test of the degree of competition will allow one to overcome some of these concerns. It will also allow a comparison of results to other approaches of measuring competition, such as using concentration ratios, the number of banks in a market, or outcomes such as banking margins. Structural competition tests have been applied to banking systems in a number of individual countries but not on a broad cross-country basis. The purpose of this paper is to estimate and document a measure of competition for a large cross-section of countries and to find factors that help explain differences in this measure. …