Competition in Banking - Suryam Babu Dirisam Abstract: This paper analyzes the degree of concentration, competition, efficiency and their relationship in the Indian banking sector over the period 1980-2011. The sample period is divided into three sub-periods: pre-reforms period (1980-89) liberalization period (reforms 1990-1998), and post-reform period (1999-2011). The analysis is carried out using bank level balance sheet data by employing structural measures (CR3, CR5, CR8 and HHI on total assets and deposits), non-structural measures (Panzar – Rosse model on total revenue and interest revenue as the dependent variables), Data Envelopment Analysis (DEA), and Granger- causality test. Our results indicate that Indian banking sector was highly concentrated, efficient and competitive in the pre- reforms period. However it is not the case in the reforms and post-reforms periods. There is a significant declining trend in terms of concentration, efficiency and competition. Granger- causality test reveals that when the competition is measured using total revenue as the dependent variable then efficiency Granger-causes the competition and competition does not Granger- cause the efficiency. On the other hand, when the competition is measured using interest revenue as the dependent variable then competition Granger-causes the efficiency and efficiency does not
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Competition in Banking
- Suryam Babu Dirisam
Abstract:
This paper analyzes the degree of concentration, competition, efficiency and their relationship in
the Indian banking sector over the period 1980-2011. The sample period is divided into three
sub-periods: pre-reforms period (1980-89) liberalization period (reforms 1990-1998), and post-
reform period (1999-2011). The analysis is carried out using bank level balance sheet data by
employing structural measures (CR3, CR5, CR8 and HHI on total assets and deposits), non-
structural measures (Panzar – Rosse model on total revenue and interest revenue as the
dependent variables), Data Envelopment Analysis (DEA), and Granger-causality test. Our results
indicate that Indian banking sector was highly concentrated, efficient and competitive in the pre-
reforms period. However it is not the case in the reforms and post-reforms periods. There is a
significant declining trend in terms of concentration, efficiency and competition. Granger-
causality test reveals that when the competition is measured using total revenue as the dependent
variable then efficiency Granger-causes the competition and competition does not Granger-cause
the efficiency. On the other hand, when the competition is measured using interest revenue as the
dependent variable then competition Granger-causes the efficiency and efficiency does not
Granger-cause the competition. On the whole, Indian banking industry operates under
monopolistic competition.
JEL classification: C22 C23; G21; L12
1. Introduction
Financial deregulation, advance in information technology and financial globalization triggered
fierce competition among banks and necessitated consolidation to reduce risk through business
diversification and take advantage of scale and scope economies. The competition effect would
depend on the degree of concentration, the degree of entry barriers, the heterogeneity of
products, and price differentiation allowed. Depending on the level of competition of the banking
industry, consolidation influences the provision of credit to different customer groups. There are
divergent views on the relationship between concentration and competition. Some argue that
concentration will intensify market power and thereby obstruct competition and efficiency.
Others argue that economies of scale drive bank mergers and acquisitions so that increased
concentration goes hand-in-hand with efficiency improvements. In terms of stability, greater
concentration may augment the size, market power, and profits of banks and thereby enhance
diversification and create greater incentives for secure banks to avoid imprudent risk-taking. The
standard economic argument for the positive influence of competition on firms’ performance is
that the existence of monopoly rents gives managers the potential to capture some of them in the
form of slack or inefficiency. Therefore, deregulation-induced competition should in turn
translate into incentives for managers to improve efficiency and performance. On the other hand,
the aim of prudential re-regulation is to foster stability and minimize excessive risk taking. As a
consequence, it imposes higher costs and could hamper competition, therefore, resulting in a
decrease in firms’ efficiency and performance.
After nationalization of banks in 1969, India did not allow entry of private sector banks until
early 1990s when barriers to entry for private sector banks were removed. India also liberalized
the entry of foreign banks in the post-reform period. These liberalized measures resulted in entry
of many new banks (private and foreign). Accordingly, the number of banks increased during the
initial phase of financial sector reforms. However, the pace of consolidation process gathered
momentum from 1999-2000, leading to a marked decline in the number of private and foreign
banks. The banking sector reforms undertaken in India in the early 1990 were aimed at ensuring
the safety and soundness of financial institutions and at the same time making them efficient,
functionally diverse, and competitive. Reforms also brought about structural changes in the
financial sector by recapitalizing them, allowing profit making banks to access the capital market
and enhancing the competitive element in the market through the entry of new banks. Apart from
achieving greater efficiency by introducing competition through the new private sector banks and
increased operational autonomy to public sector banks, reforms in the banking system were also
aimed at enhancing financial inclusion, funding of economic growth and better customer service
to the public.
Indian financial consolidation has implications not only for competition but also for financial
stability, monetary policy, efficiency of financial institutions, credit flows and payment and
settlement systems. For instance, financial consolidation led to higher concentration in countries
such as US and Japan, though they continue to have much more competitive banking systems as
compared with other countries. However, in several other countries, the process of consolidation
led to decline in banking concentration, reflecting increase in competition. This was mainly
because banks involved in M&As were of relatively small size (RBI, Currency and Finance
report, 2008).
Much of the consolidation activity in France took place during the 1990s among small banks
leading to a large reduction in the total number of banking institutions. Similarly, in Germany
consolidation took place among smaller savings and co-operative banks, thereby leading to
decline in the number of banks by about a third during the 1990s (see currency & finance report
2008 for better reference). Following consolidation, the number of banks in Italy also declined
by more than a third during the same period. A combination of dismantling of restrictions on
inter-state and intra-state banking, removal of interest rate ceilings on small time and savings
deposits and permission on diversification of activities paved the way for mergers between banks
and non-bank financial companies in the US during the 1990s. The consolidation that followed
resulted in substantial growth, in both absolute and relative terms, by the largest institutions. In
the UK, the regulatory reforms during the 1980s and the 1990s removed restrictions on financial
institutions to compete across traditional business lines (RBI, Currency and Finance report,
2008).
In Canada, domestic banks traditionally controlled a large share of the banking sector. Owing to
the dominance of the banking industry by a few banks, consolidation is regulated through a
guideline established in 2000 to ensure that it does not lead to unacceptable level of
concentration and drastic reduction in competition and reduced policy flexibility in addressing
future prudential issues. Thus, not much consolidation took place during the 1990s and the
number of banks did not decline much from the substantial increase observed during the 1980s
due to entry of foreign banks. In Japan also, little consolidation took place during the 1990s and
there was only a modest reduction in the number of banks at the end of the 1990s following some
bank failures. The banking industry in Sweden during the 1990s experienced the merger of co-
operative banks into one commercial bank and transformation of the largest savings banks into
one banking group. Further, there was consolidation among all the major banking groups. While
all the above mergers reduced the number of banks, the total number of banks increased
somewhat due to entry of foreign banks and the establishment of several ‘niche banks’ around
the same time (RBI, Currency and Finance report, 2008).
Given the state of the inconclusive literature on the impact of Concentration, Competition,
Efficiency and their relationship in the banking industry that is discussed above, the current
study aims at examining the impact and degree of concentration, competition, efficiency and
their relationship in the Indian banking industry during the period 1980-2011. To this end, the
present study uses various measures like the structural measures (such as CR3, CR5, CR8 and
HHI on total assets and deposits), non-structural (Panzar – Rosse model on total revenue and
interest revenue as the dependent variables), Data Envelopment Analysis (DEA), and Granger-
causality test.
The present study makes some contributions to banking industry literature. Firstly, to the best of
our knowledge it is only the study that includes pre-liberalization period in the examination,
where as the rest of literature has been focusing on liberalization and post-liberalization periods.
Secondly, it is the first study from the developing world1 that incorporates the efficiency into
competition evaluation and also it is the first study that evaluates the formal relationship between
competition (Panzar - Rosse H-stat) and efficiency2 using Granger-causality test.
Rest of this paper is structured as follows. Section 2 briefs about the Indian banking sector since
1980. Section 3 gives a brief related literature review. Section 4 provides data and methodology,
while Section 4 offers empirical results and discussion. Some conclusions are offered in the final
section.
2. Indian Banking sector at a glance since nationalization
1 2 However there is a study by AP-Podpiera et al (2008) in the literature but this study did not used the standard Granger-causality test and also the competition was measured by Learner index and not by Panzar-Rosse model.
In the pre-independence period and even in the post independence period, failure of banks was a
regular feature. The banking industry at that time was in the hands of private entrepreneurs.
Hence, whenever a bank failed, its customers were simply cheated and their earned money was
forfeited. In order to protect the public interest, nationalization of banks was done in 1969 and
then in 1980. Before nationalization, banks mostly operated in the urban and semi urban areas.
Banking facilities were out of the rural people. With the nationalization of banks, public sector
banks accounted for nearly 90 percent of the banking system of the country. A review of the
performance of banking sector in the early 1990s reveals that despite the overall progress made
by banking system in geographical and functional coverage, its operational efficiency had been
unsatisfactory, characterized by low profitability, high non-performing assets and relatively low
capital base.
Serious inflationary pressures, emerging scarcities of essential commodities and breakdown of
fiscal discipline gave birth to the economic reforms. In 1991, financial sector reforms were
introduced on the basis of Narasimham Committee Report. According to this committee, the
measures recommended were intended to improve the financial health of banks and development
of financial institutions in order to make them more viable and efficient. The recommendations
of the committee regarding the monetary policy issues i.e. reduction of statutory Liquidity Ratio
(SLR) from 38.5 per cent to 25 per cent, reduction in Cash Reserve Ratio (CRR) from a high of
15 per cent and deregulation of the interest rates, were successfully implemented. The reform
process initiated in 1991 has posed many threats and challenges before the bankers as never
before. Bankers who worked with public sector during 1970-90 had their tasks defined for them.
The emergence of new private sector banks and foreign banks with high degree of technology
and automation right from the birth have thrown a real challenge, threat to the continued
profitability of the public sector banks (Uppal, 2005).
In line with the recommendations of the second Narasimham Committee, in October 1999 the
Mid-Term Review of the Monetary and Credit Policy of October 1999 announced a gamut of
measures to strengthen the banking system; The Reserve Bank undertook several measures to
further facilitate the deregulation and flexibility in interest rates. First, the Reserve Bank allowed
banks the freedom to prescribe different prime lending rates (PLRs) for different maturities.
Banks were accorded the freedom to charge interest rates without reference to the PLR in case of
certain specified loans. Banks may also offer fixed rate term-loans in conformity with the ALM
Variable description: TACR3, TACR5, and TACR8 are the concentration ratios based on total assets. DCR3, DCR5, and DCR8 are the concentration ratios based on deposits. THHI and DHHI are the Herfindahl-Hirschman Indices based on total assets and deposits respectively.DEA is the average annual efficiency score. 1PR1 &2PR1are the H-stats calculated total revenue and interest revenue as the dependent variable. 2PR1 &2PR2are the H-stats calculated total revenue and interest revenue as the dependent variable and DEA included as the bank specific factor.
Table 3: Various concentration, competition and efficiency results from 1998 to 2011.
5 H-stat is based on P-R model total revenue as the dependent variable without DEA as the bank specific factor.6 H-stat is based on P-R model interest revenue as the dependent variable without DEA as the bank specific factor.
F-stat up to lag1 4.63**(0.046) 1.26(0.278) 1.24(0.281) 3.99*(0.062)
F-stat up to lags2 3.45*(0.055) 0.70(0.512) 0.91( 0.422) 2.15(0.147)
F-stat up to lags3 2.31( 0.113) 0.60(0.626) 0.63(0.603) 1.43( 0.268)
F-stat up to lags4 2.66 *(0.069) 1.18(0.356) 1.55 (0.232) 1.37(0.286)
R2 70.57% 81.67% 66.02% 82.29%
N 27 27 27 27
*, **, *** denote an estimate significant at 10%, 5% and 1% level. The values in the parenthesis of the coefficients represent the t-values and of the F-stats represent p-values.
5.0. Conclusions
Competition is generally considered as a positive force, often associated with increased
efficiency and enhanced consumers’ welfare. However, competition in the banking sector is a
more controversial issue (Bikker, 2004). The acceleration in the financial consolidation since
nationalization of the Indian banking sector has been raising many concerns about the level of
concentration, competition and efficiency. Using bank level balance sheet data of Indian
commercial banking sector, this paper aims at analyzing the state of the concentration,
competition, efficiency and the relationship among them since nationalization (1980) of the
Indian banking sector. Various standard measures like concentration ratios, Herfindhal index,
Data Envelopment Analysis (DEA), Panzar–Rosse model and Granger-Causality test are used to
analyze state and the relationship among concentration, competition and efficiency from 1980 to
2011.
An analysis of the structural concentration measures (CR3, CR5, CR8 and HHI) on total assets
and deposits indicate that Indian banking sector was highly concentrated during pre-reform
period (1980-89). However it started decreasing since the liberalization of the banking sector and
same decreasing pattern continued in the post liberalization period (liberalization period, 1990-
1998 and post-liberalization period 1999-2011). The average annual DEA efficiency (BCC
model, variable returns to scale) scores for the Indian banking sector over the full sample period
is 74.60 percent indicating a 25.40 percent average potential reduction in the input utilization.
The sub-sample averages as follows: 88.90 percent for the period (pre reform) 1980-1988-89,
69.90 percent for the period (during liberalization) 1990-1998, and 66.30 percent for the period
1999-2011. So, it is evident from the efficiency scores that Indian banking sector is not efficient
either in the pre-reform period or during and in the post reform periods. However Indian banks
were better off in the pre-reform period compared to during and post reform period in terms of
efficiency levels.
Analysis of the non-structural Panzar–Rosse H-statistic indicates that in the pre-reform period
there was high competitiveness initially, but later on the competition decreased. However it got
momentum by 1985 and reached the highest competitive level by the year 1988-89 and in the
same year (i.e. 1988-89) the model interest revenue as dependent variable without the annual
DEA efficiency score as the bank specific factor shows perfect competition in the Indian banking
sector. During the liberalization period there was huge volatility in the competition levels. In the
Initial years of the reform period, Indian banking sector showed high competitiveness but it fell
down by 1992. However it got the momentum by 1995, but again it shows a declining trend from
1996 onwards in the competitive levels. Again the post reform period also exhibits huge
volatility in the banking competition levels. In the initial years it had shown less competitive
conditions but it picked up the momentum in the competition levels by 2004. However banks
showed relatively more competitiveness in the second half of the post reform period compared to
first half of the post reform period. Finally the year 2011 shows highest competition in the post
reform period. On the whole Indian banking sector is operating under monopolistic competition
and these results corroborate the study of Prasad and Ghosh (2005).
Granger-causality test results indicates in the first case (where the competition is measured using
total revenue as the dependent variable without including DEA as the bank specific factor in the
model) the efficiency Granger-causes the competition and competition does not Granger-cause
the efficiency. An opposite pattern is found in the second case (where the competition is
measured using interest revenue as the dependent variable without including DEA as the bank
specific factor in the model) where competition Granger-causes the efficiency and efficiency
does not Granger-cause the competition.
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