Competition in the Banking Industry: Implication on Financial Sector Development

By Onodugo, Ifeanyi Chris; Okoro, Okoro E. U. et al. | Journal of Community Positive Practices, July 1, 2016 | Go to article overview

Competition in the Banking Industry: Implication on Financial Sector Development


Onodugo, Ifeanyi Chris, Okoro, Okoro E. U., Amujiri, Benjamin A., Onodugo, Vincent A., Journal of Community Positive Practices


Introduction

The banking industry plays an essential role in the economy in terms of resource mobilization and allocation and, is by far, the most important part of the financial system in developing economies, accounting for the bulk of the financial transactions and assets (Moyo, Nandwa, Odour and Simpasa, 2014). In addition, banks have recently expanded in other activities such as securities markets, fund management, insurance, among others, blurring the distinction between banks and other financial markets. Accordingly, it is expected that through reforms (increased competition), banks can potentially be the main source of financial innovation and efficiency or, in a worst case scenario, as a source of systemic risk to the financial structure through contagion, thus engendering macroeconomic instability and diminished investment and growth. The latter phenomenon was aptly evidenced by the recent global financial crisis which had its origin in excessive risk-taking behavior through the use of leveraged asset-price derivatives by financial institutions, mostly banks.

Notably, in developing countries, lack of well-developed domestic capital markets and access to international capital markets makes the banking sector ubiquitous and, therefore, any systemic bank failures would have serious contagious repercussions in such economies.

Competition in the financial sector matters for a number of reasons. As in other industries, the degree of competition in the financial sector matters for the efficiency of production of financial services, the quality of financial products and the degree of innovation in the sector. The view that competition in financial services is unambiguously good, however, is more naive than in other industries and vigorous rivalry may not be the first best. Specific to the financial sector is the effect of excessive competition on financial stability, long recognized in theoretical and empirical research and, most importantly, in the actual conduct of (prudential) policy towards banks. There are other complications, however, as well. It has been shown, theoretically and empirically, that the degree of competition in the financial sector can matter (negatively or positively) for the access of firms and households to financial services, in turn affecting overall economic growth.

In terms of the factors driving competition in the financial sector and the empirical measurement of competition, one needs to consider the standard industrial organization factors, such as entry/exit and contestability. But financial services provision also has many network properties, in their production (e.g., use of information networks), distribution (e.g., use of ATMs), and in their consumption (e.g., the large externalities of stock exchanges and the agglomeration effects in liquidity). This makes for complex competition structures since aspects such as the availability of networks used or the first mover advantage in introducing financial contracts become important.

Not only are many of the relationships and tradeoffs among competition, financial system performance, access to financing, stability, and finally growth, complex from a theoretical perspective, but empirical evidence on competition in the financial sector has been scarce and to the extent available often not (yet) clear. What is evident from theory and empirics, however, is that these tradeoffs mean that it is not sufficient to analyze competitiveness from a narrow concept alone or focus on one effect only. One has to consider competition as part of a broad set of objectives, including financial sector efficiency, access to financial services for various segments of users, and systemic financial sector stability, and consider possible tradeoffs among these objectives. And since competition depends on several factors, one has to consider a broad set of policy tools when trying to increase competition in the financial sector.

Received evidence shows that in developing countries with transparent financial regimes where financial sector reforms have been implemented, competition in the banking industry has generally improved2 compared to countries characterized by less transparent financial sector regimes

(Ariss, 2010; Beck, Demirguc-Kunt, & Levine, 2009; Claessens & Laeven, 2004). …

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