Chapter

IX Competition in the Banking System

Author(s):
Vladimir Klyuev, Martin Mühleisen, and Tamim Bayoumi
Published Date:
October 2007
Share
  • ShareShare
Show Summary Details
Author(s)
Iryna V. Ivaschenko1

There is ongoing discussion on the merits of allowing mergers between Canada’s large financial institutions. Some analysts argue that a lack of mergers may constrain banks’ ability to compete internationally, given the comparatively small size of the Canadian market.2 Others caution that mergers would increase the already high concentration in Canada’s banking sector, adversely affecting competition and thus consumer interests.3 Some observers are particularly concerned about the prospect of mergers among the six largest banks, which account for about 90 percent of all banking assets.

This section uses an industrial organization (IO) approach to measure the degree of competition among the largest Canadian banks compared with other countries. In particular, it analyzes competition in banking systems that have more banks than Canada, such as the United States, which has a large and fragmented banking system; the United Kingdom, which has fewer banks; and continental Europe.

Optimal Level of Bank Competition: A Review of the Literature

The literature is inconclusive on the relative merits of a highly competitive banking system versus a structure that retains some degree of monopolistic power.4 This applies to the literature studying the consequences of competitive structures for allocative efficiency and productivity, as well as to work looking into the effects on banking system stability. Theoretical results largely depend on which particular model is chosen, and empirical approaches have also failed to support any firm conclusion.

Standard IO methods applied to the banking industry suggest that perfect competition fosters allocative efficiency by channeling credit to its most productive use. However, other theoretical approaches that take into account some specific aspects of the banking business—such the presence of information asymmetry and the effect of a bank’s net worth on the quantity of credit supplied—suggest that a banking system with some market power may provide more and higher-quality credit. This result rests on the argument that banks with some monopoly power are more prepared to engage in costly activities that mitigate information asymmetries, such as relationship lending and screening (Petersen and Rajan, 1995; Cetorelli and Peretto, 2000).5 Empirical studies also have failed to find convincing evidence that market power is detrimental to credit allocation (Northcott, 2004, and references therein). Earlier studies found a negative relationship between the degree of competition and bank profits, but the results were not robust across time, products, or profit specification. More recent research has found that this relationship is weakened or eliminated if differences in banks’ productive efficiency are taken into account (see Berger, 1995; and Punt and van Rooij, 2001).

Standard IO methods also suggest that perfect competition achieves productive efficiency because it maximizes the quantity of credit supplied at the lowest interest rate. However, the results are not clear-cut once economies of scale—which usually exist in banking—are taken into account. Berger and Mester (1997) review studies that highlight some empirical evidence pointing at inefficiencies in banking, but it is not clear whether these arise from a lack of competition or unrealized scale economies.

There is no consensus in the literature on what market structure may promote prudent behavior, which benefits the stability of the financial system. Some studies suggest that market power may encourage prudent risk-taking and screening of borrowers, improving loan quality (Keeley, 1990; Salas and Saurina, 2003). However, other research finds that strong regulations and disclosure requirements can mitigate risk-taking and promote screening regardless of the competitive environment (Cordella and Levy Yeyati, 2002).

Methodology and Data

This paper uses a standard IO approach to assess the competitiveness of large Canadian banking groups. The Panzar-Rosse approach measures market power by the extent to which changes in factor prices are reflected in revenues. Under perfect competition, an increase in factor prices induces a proportional change in revenues because firms face perfectly elastic demand for their products. Conversely, under monopolistic competition, revenues change less than proportionally in response to changes in factor prices. In the case of a perfect monopoly, there may be no response or even a negative response of revenues to changes in input costs. To measure the degree of competition in a particular market, Panzar and Rosse (1987) proposed the so-called H-statistic, which is computed as the sum of elasticities of revenues to unit factor costs in a reduced form revenue equation.

Although not initially intended to be applied to the financial system, Panzar and Rosse’s original methodology has since been adapted to investigate the competitive structure of banks.6 Applications in the literature include the cases of Germany and several European countries (De Bandt and Davis, 2000; and IMF, 2003); the United States (Shaffer, 1982); and Canada (Nathan and Neave, 1989). Canada’s broad financial system was found not to exhibit monopoly power at the time, but the consolidation that has taken place in recent years suggests a need to revisit this result.

Following the approach of Nathan and Neave (1989), the following base model was estimated:

where INCNET is net income, PFUND is the unit price of funds, PCAP is the unit price of capital, PLAB is the unit price of labor, and ASST total assets. Total assets are included to identify possible scale economies, given the wide range of asset sizes across countries. For this model, H = α + β + γ. In a perfect competition case H = 1. A positive value of H, which is below unity, indicates monopolistic competition, with higher values of H corresponding to a more competitive industry. Negative values of H could indicate either that the banking system is perfectly monopolistic or that the market is not in equilibrium (for example, because of structural change), in which case the H-statistic could not be applied.7

This analysis uses annual BankScope data for the largest banks in Canada, the United States, Germany, France, Italy, and the United Kingdom from 1999 to 2003. The unit price of funds was calculated as interest expenses over total deposits, the unit price of labor as personnel expenses over total liabilities, and the unit price of capital as other expenses divided by total liabilities.8 The sample contains 35 banks in Canada, 27 of the largest U.S. banks, 290 French banks, 266 German banks, 127 Italian banks, and 200 banks in the United Kingdom.

Results

The empirical evidence supports the view that Canadian banks have grown more slowly than their major foreign competitors (Table 9.1). Although the Canadian Big Six have maintained profit growth, they have lagged their U.S. counterparts in profitability and, particularly, in balance sheet growth. The average size of the Big Six was comparable to banks in the United States and the United Kingdom in 1999. By 2003, however, large Canadian banks were on average 12 percent smaller than U.S. banks and more than 60 percent smaller than banks in the United Kingdom.

Table 9.1.Size and Profitability Indicators of 25 Largest Banks
CountryTotal Assets1

(billion US$)
Return on

Assets
Return on

Equity
1999
Canada37.40.68.6
Big Six137.00.815.9
France113.00.52.5
Germany75.70.25.0
Italy55.90.910.8
Spain29.81.011.0
United Kingdom151.00.818.2
United States143.01.618.1
2003
Canada52.40.89.4
Big Six195.00.814.7
France154.00.34.3
Germany140.00.11.9
Italy68.50.36.0
Spain45.80.910.0
United Kingdom325.00.612.3
United States217.01.616.7
Source: BankScope.

The Panzar-Rosse competitiveness measure provides a mixed assessment of the competitiveness of the Canadian banking system. The statistic was calculated for all banks in the sample, based on a fixed-effect panel estimation.9 The results indicate that the banking system in Canada is slightly more competitive than those in continental Europe, the United Kingdom, and the 27 largest national banks in the United States (Table 9.2). At the same time, the H-statistics for the Big Six banks is negative, which could suggest the presence of some monopolistic power. Canada is clearly not a case with large banks operating as a perfect monopoly, given that the H-statistic is not significantly different from zero, but alternative tests confirm that the Panzar-Rosse statistic is valid and not tainted by structural change.10

Table 9.2.H-Statistics, by Country and Region
RegionH-Statistics1Standard ErrorP-Value
All countries0.509**0.0840.000
United States20.2830.1820.119
United Kingdom0.581**0.0870.000
Continental Europe0.321**0.1920.095
France1.1504.2000.784
Germany0.482**0.1340.000
Italy0.471**0.1270.000
Spain0.283**0.1220.020
Canada, all banks0.698**0.1780.000
Canada, Big Six3−0.3890.3910.319

The analysis indicates that Canada is not the only country where large banks seem to enjoy some pricing power. The level of competition among large institutions in other countries varies considerably and—as in Canada—differs from the competitiveness measure of the broader system for some countries. For example, when comparing the 25 largest banks by asset value across countries, the results suggest that only U.K. and Spanish large banks operate in a fully competitive environment (Table 9.3). All other countries are similar to Canada in that large banks enjoy some degree of monopolistic power.

Table 9.3.H-Statistics for Largest Banks, by Country and Region
RegionH-Statistics1Standard ErrorP-Value
Panel A. Banks accounting for 95 percent of total consolidated assets
All countries0.1800.1120.108
United States0.2610.1850.158
United Kingdom0.528**0.1660.001
France0.6290.3850.102
Germany−0.9472.0360.642
Italy0.0250.1700.884
Spain0.421**0.1570.007
Canada−0.3890.3910.319
Panel B. Banks accounting for 90 percent of total nonconsolidated assets
All countries0.416**0.1230.001
United States0.2610.1850.158
United Kingdom0.509**0.1450.000
France0.584**0.2860.041
Germany−0.0210.6090.972
Italy0.2950.3890.447
Spain0.520**0.1570.001
Canada−0.2490.5310.639
Source: IMF staff calculations.

The results also reveal that the number of large banks in a country is not as important for the level of competition as their combined market share. For example, the Panzar-Rosse measure calculated for banks that hold 95 percent of a country’s total consolidated bank assets—equal to the market share of the Canadian Big Six—again suggests that banking systems in the United Kingdom and Spain are particularly exposed to competition (Table 9.3, upper panel).11 However, competition increases across countries if the analysis is limited to banks that only account for 90 percent of total assets (Table 9.3, lower panel). At the same time, the number of banks accounting for a given level of bank assets varies greatly across countries and is not correlated with the Panzar-Rosse statistic (Table 9.4).

Table 9.4.Size and Concentration of Banking Systems across Regions,2003
Size

(billion US$)
Number of Banks Holding

95 Percent of Assets

(Consolidated)
Number of Banks Holding 90

Percent of Assets

(Nonconsolidated)
Canada1,27466
France3,7641217
Germany2,264414
Italy2,7838722
Spain1,4931511
United Kingdom7,2261217
United States17,8092525
Sources: Statistics Canada; U.S. Federal Reserve; Primark DataStream; and BankScope.

Conclusions

This section analyzes the level of competition in the Canadian banking system, with a particular focus on the six large banks, and compares it with banks in other industrial countries. Using an approach from the IO literature, the analysis does not reject the hypothesis that the Big Six may enjoy some degree of market power, although the broad banking system in Canada is found to be strongly competitive. The analysis of other countries reveals similar differences between large banks and the total banking system, with the United Kingdom and Spain being the only countries where large banks appear to operate in a fully competitive environment. The analysis also finds that the number of large banks in a country is not as important for the level of competition as their combined market share.

This section benefited from comments provided by the Bank of Canada and the Canadian Department of Finance.

In an interview on September 3, 2004, Industry Minister David L. Emerson said that Canadian banks risk becoming low-level players on global lending markets if Ottawa does not allow them to merge. See also Bond (2003).

For example, a majority of respondents to a recent survey conducted among members of the Canadian Federation of Independent Business and other small and medium-sized enterprises agreed that competition in the financial services sector should increase before additional bank mergers were approved.

See Northcott (2004) for a comprehensive review of the literature.

In addition, Petersen and Rajan (1995), using U.S. data, also found that supply of credit to young firms is greater in the system with market power, which should encourage innovation and productivity growth.

The extension of the Panzar-Rosse methodology to banking requires banks to be treated as single-product firms, consistent with the intermediation approach to banking in which banks are viewed as financial intermediaries (see Colwell and Davis, 1992, for details).

The Panzar and Rosse (1987) model is based on the premise that the competitive structures under analysis are in a long-term equilibrium. Adjustments to shocks or structural change could affect the way changes in factor prices translate into revenue changes, rendering the H-statistic less useful.

The cost per square foot of premises would be a better measure of the cost of physical capital, but these data are not currently available.

The fixed-effect approach was suggested by a Hausman test.

As discussed above, the negative value of the H-statistic could also indicate that the Canadian banking system goes through a period of structural change, in which case the Panzar-Rosse approach would not be valid. However, Shaffer (1982) argued that the return on assets or on equity (ROA or ROE) should not be correlated with input prices in the absence of structural change. Therefore, equation (1) was re-estimated with log ROA on the left-hand side. The hypothesis H=0 could not be rejected, suggesting that the Panzar-Rosse statistic is valid in Canada’s case.

For Canada, the market share of the Big Six only takes into account domestic banking assets, excluding foreign subsidiaries and credit unions.

    Other Resources Citing This Publication