Competition, a reality in banking industry
Saturday, 31 December 2011
The banking industry across the globe has become increasingly concentrated over the past few decades especially in the developed countries. In the United States of America, the market share of the five biggest banks has increased to 34 per cent, from less than 8.0 per cent in 1994. Banks that before the financial crisis were thought to be too big to be allowed to fail have grown even bigger and the vulnerable financial institutions have been merged with other banks.
In large parts of the world, the idea of having a few very big banks is generally thought to be a better option. The experts and regulators thought that cosy banking oligopolies were so profitable that banks should not take any risks lest they upset their status quo. Moreover, having just a few big banks meant that regulators could watch them closely.
The central banks are busily trying to force the big banks to divest. Britain wants its banks to erect firewalls between their different operations. Although not exactly splitting them up, it wants dotted lines drawn to allow for easy separation should that be required. And in the US, officials are pushing hard to tilt the competitive playing field in a way that will advantage smaller banks.
In Bangladesh, the central bank has recently made a quick u-turn in response to the directives of the Ministry of Finance and others regarding approving new banks. The reason behind this radical change in policy-making by the same officials who argued against allowing new banks earlier, needs a little discussion here.
In the recent global financial crisis the banking sector of Bangladesh was not directly affected because our banking industry has limited global involvement or exposure. Another major reason is the absence of sub-prime mortgage dealings in our banking sector. We should not be complacent about our banks being financially stronger and safer than those of the developed countries.
In most sectors of the economy, there is broad agreement that competition is good for consumers because it promotes innovation and drives down prices. An ideal regulation is a means of maintaining optimum competition for reaching the stability in the banking industry. More competition can also broaden the customer base of the financial system, leading to greater diversification of risks, whereas large concentration of banks can pose systemic risks because they are interconnected.
Some experts point to the fact that the arguments around competition and financial stability run both ways and it is ultimately a question of finding the right balance between competition and regulation. Competition is a reality, regulation is a controlling device and stability is the objective of the banking industry. Yet that still leaves regulators and policymakers with a dilemma. For even if they manage to tackle the myriad of complex regulatory challenges they already face, should they also be directly challenging the structure of the industry and should they be encouraging further competition or do we have quite enough already?
However, the answer is not that easy at all. The issue of whether competition in the banking industry is good or bad for the financial stability is a very complex one. If it is assumed as good, how much of that is good? If it is bad, how can it be regulated properly? The issue merits special attention from the respective monitoring and supervising authority.
Traditionally, it has been argued that the less competition there is in a country's banking system the more stable it is likely to be. This is known as the "charter value" hypothesis. The idea is that banks will be more valuable in a concentrated system and owners will be less willing to take risks. As a result, the whole banking system will not suffer any consequences arising from tough competition among them. A recent counter-argument is that it is necessary to look at the loan market as well. A more competitive banking industry means that the interest rate on loans will be lower. Borrowers will then be more profitable and as a result they will be less willing to take risks so the stability of the banking system will be maintained. The overall outcome will depend on the relative strength of the two effects.
The experience of a number of countries in the past and during the recent crisis provides some insights into the relevant issues. Historically, the comparison that has often been made is between the stability of the Canadian banking system compared to the United States' experience. In the late nineteenth and early twentieth centuries, the US had many banking crises while Canada did not. The standard explanation for this is that Canada had a few large banks while the US had many small banks.
In the recent crisis, the banking system in Canada and also that in Australia were very resilient. Six banks dominate the Canadian financial system, while there are four major banks together with a few small domestic banks in Australia. However, the United Kingdom, which has a similar structure to Australia with four major banks and a few other small domestic and foreign banks, had a very different experience.
We cannot be assured that the charter value hypothesis will work the same for all banks. The hypothesis worked for Canada and Australia but did not do the same for the banking system of the United Kingdom in spite of having the same type of banking structure. So, definitely there must have been some other variables influencing the banking sector as well.
In addition to the competitive nature of the industry, funding structure, institutional and regulatory environments are important. These factors are well illustrated by the recent experience of Canada, Australia and the UK. Canadian and Australian banks mainly relied on depository funding. This funding source proved stable through the crisis. On the other hand, British banks have increasingly used wholesale funding from financial markets. Canada and Australia also have much stricter regulatory environments than the UK. For example, in Canada capital regulation is stricter than the Basel agreements require. Banks' foreign and wholesale activities are limited. The mortgage market is conservative in terms of the products offered with less than 3.0 per cent being sub-prime and less than 30 per cent being securitised. In the UK, a "light touch" regulatory framework was implemented.
So, the uncertainty in the relationship between competition and financial stability is certain. While there are many historical examples of stable financial systems with limited competition such as Canada, there seem to be relatively few examples of highly competitive stable banking systems. There lies the necessity of proper regulation for maintaining the optimum competition in banking industry, one of the most sensitive financial sectors. The central banks are those who should play this decisive role in every country.
Competition may be a boon or a bane and it depends on the regulatory framework. The commercial banks are run as per this framework which sets their risk-taking incentives that drives stability or fragility of the whole banking system of a country. Competition can be a powerful source of useful innovation and efficiency, ultimately benefiting enterprises and households. It can foster stability through improved lending technologies. However, it can also endanger stability if mixed with the wrong kind of regulation. The nature of competition does not matter, but the nature of regulation does. If the regulation is on right track the evil competition will be wiped out by the constructive contest among the players. Competition between a few large banks in a concentrated banking system can become fierce, especially if they operate across the same markets and product differentiation is limited.
Competition can foster efficiency in banking, putting downward pressure on interest margins, resulting in higher deposit rates for savers and lower lending rates for borrowers. It can push the banking systems towards new, previously unbanked groups, foster the development of new products, with ultimately positive repercussions for private sector development, individual welfare, and economic development. It can also result in more stability as lending techniques improve, and banks are better able to screen and monitor their borrowers. This is especially important in developing countries, where finance is characterised by a lack of players and products and limited financial service options for households and enterprises.
On the dark side, and as we have seen in the recent crisis, competition can undermine franchise values of banks, tempting them to take aggressive risks, and lead to herding trends, with financial institutions taking similar risks and bets, ultimately increasing systemic fragility and contagion risks. Aggressive competition makes the industry chaotic and the contestants tend to adopt any means forgetting the national economic interest. As a result, the industry becomes vulnerable.
However, competition can also be good for stability. Lower interests entice borrowers to take lower risks, ultimately leading to less bank fragility. More competition can lead to a broadening of the customer base of the financial system, resulting in better diversification of risks. Finally, higher competition allows regulators to more easily resolve a failing bank by selling its good assets together with insured liabilities to a competitor.
Similarly, concentrated banking systems with a few and large banks have a bright and a dark side to them. Large financial institutions can diversify more easily across sectors and regions. They can exploit scale economies, especially important in small developing countries in order to reduce costs and increase outreach. However, inter-linkages between a few institutions can more easily lead to contagion effects. The failure of large financial institutions imposes high costs on the rest of the financial system and the economy; knowing their too-big-to-fail status, these institutions tend to be more aggressive in their risk-taking decisions and hold less capital.
The writer is Officer at the Islami Bank Bangladesh Ltd (Foreign Exchange Department), and can be reached at email: nurul islam soheljec@yahoo.com
In large parts of the world, the idea of having a few very big banks is generally thought to be a better option. The experts and regulators thought that cosy banking oligopolies were so profitable that banks should not take any risks lest they upset their status quo. Moreover, having just a few big banks meant that regulators could watch them closely.
The central banks are busily trying to force the big banks to divest. Britain wants its banks to erect firewalls between their different operations. Although not exactly splitting them up, it wants dotted lines drawn to allow for easy separation should that be required. And in the US, officials are pushing hard to tilt the competitive playing field in a way that will advantage smaller banks.
In Bangladesh, the central bank has recently made a quick u-turn in response to the directives of the Ministry of Finance and others regarding approving new banks. The reason behind this radical change in policy-making by the same officials who argued against allowing new banks earlier, needs a little discussion here.
In the recent global financial crisis the banking sector of Bangladesh was not directly affected because our banking industry has limited global involvement or exposure. Another major reason is the absence of sub-prime mortgage dealings in our banking sector. We should not be complacent about our banks being financially stronger and safer than those of the developed countries.
In most sectors of the economy, there is broad agreement that competition is good for consumers because it promotes innovation and drives down prices. An ideal regulation is a means of maintaining optimum competition for reaching the stability in the banking industry. More competition can also broaden the customer base of the financial system, leading to greater diversification of risks, whereas large concentration of banks can pose systemic risks because they are interconnected.
Some experts point to the fact that the arguments around competition and financial stability run both ways and it is ultimately a question of finding the right balance between competition and regulation. Competition is a reality, regulation is a controlling device and stability is the objective of the banking industry. Yet that still leaves regulators and policymakers with a dilemma. For even if they manage to tackle the myriad of complex regulatory challenges they already face, should they also be directly challenging the structure of the industry and should they be encouraging further competition or do we have quite enough already?
However, the answer is not that easy at all. The issue of whether competition in the banking industry is good or bad for the financial stability is a very complex one. If it is assumed as good, how much of that is good? If it is bad, how can it be regulated properly? The issue merits special attention from the respective monitoring and supervising authority.
Traditionally, it has been argued that the less competition there is in a country's banking system the more stable it is likely to be. This is known as the "charter value" hypothesis. The idea is that banks will be more valuable in a concentrated system and owners will be less willing to take risks. As a result, the whole banking system will not suffer any consequences arising from tough competition among them. A recent counter-argument is that it is necessary to look at the loan market as well. A more competitive banking industry means that the interest rate on loans will be lower. Borrowers will then be more profitable and as a result they will be less willing to take risks so the stability of the banking system will be maintained. The overall outcome will depend on the relative strength of the two effects.
The experience of a number of countries in the past and during the recent crisis provides some insights into the relevant issues. Historically, the comparison that has often been made is between the stability of the Canadian banking system compared to the United States' experience. In the late nineteenth and early twentieth centuries, the US had many banking crises while Canada did not. The standard explanation for this is that Canada had a few large banks while the US had many small banks.
In the recent crisis, the banking system in Canada and also that in Australia were very resilient. Six banks dominate the Canadian financial system, while there are four major banks together with a few small domestic banks in Australia. However, the United Kingdom, which has a similar structure to Australia with four major banks and a few other small domestic and foreign banks, had a very different experience.
We cannot be assured that the charter value hypothesis will work the same for all banks. The hypothesis worked for Canada and Australia but did not do the same for the banking system of the United Kingdom in spite of having the same type of banking structure. So, definitely there must have been some other variables influencing the banking sector as well.
In addition to the competitive nature of the industry, funding structure, institutional and regulatory environments are important. These factors are well illustrated by the recent experience of Canada, Australia and the UK. Canadian and Australian banks mainly relied on depository funding. This funding source proved stable through the crisis. On the other hand, British banks have increasingly used wholesale funding from financial markets. Canada and Australia also have much stricter regulatory environments than the UK. For example, in Canada capital regulation is stricter than the Basel agreements require. Banks' foreign and wholesale activities are limited. The mortgage market is conservative in terms of the products offered with less than 3.0 per cent being sub-prime and less than 30 per cent being securitised. In the UK, a "light touch" regulatory framework was implemented.
So, the uncertainty in the relationship between competition and financial stability is certain. While there are many historical examples of stable financial systems with limited competition such as Canada, there seem to be relatively few examples of highly competitive stable banking systems. There lies the necessity of proper regulation for maintaining the optimum competition in banking industry, one of the most sensitive financial sectors. The central banks are those who should play this decisive role in every country.
Competition may be a boon or a bane and it depends on the regulatory framework. The commercial banks are run as per this framework which sets their risk-taking incentives that drives stability or fragility of the whole banking system of a country. Competition can be a powerful source of useful innovation and efficiency, ultimately benefiting enterprises and households. It can foster stability through improved lending technologies. However, it can also endanger stability if mixed with the wrong kind of regulation. The nature of competition does not matter, but the nature of regulation does. If the regulation is on right track the evil competition will be wiped out by the constructive contest among the players. Competition between a few large banks in a concentrated banking system can become fierce, especially if they operate across the same markets and product differentiation is limited.
Competition can foster efficiency in banking, putting downward pressure on interest margins, resulting in higher deposit rates for savers and lower lending rates for borrowers. It can push the banking systems towards new, previously unbanked groups, foster the development of new products, with ultimately positive repercussions for private sector development, individual welfare, and economic development. It can also result in more stability as lending techniques improve, and banks are better able to screen and monitor their borrowers. This is especially important in developing countries, where finance is characterised by a lack of players and products and limited financial service options for households and enterprises.
On the dark side, and as we have seen in the recent crisis, competition can undermine franchise values of banks, tempting them to take aggressive risks, and lead to herding trends, with financial institutions taking similar risks and bets, ultimately increasing systemic fragility and contagion risks. Aggressive competition makes the industry chaotic and the contestants tend to adopt any means forgetting the national economic interest. As a result, the industry becomes vulnerable.
However, competition can also be good for stability. Lower interests entice borrowers to take lower risks, ultimately leading to less bank fragility. More competition can lead to a broadening of the customer base of the financial system, resulting in better diversification of risks. Finally, higher competition allows regulators to more easily resolve a failing bank by selling its good assets together with insured liabilities to a competitor.
Similarly, concentrated banking systems with a few and large banks have a bright and a dark side to them. Large financial institutions can diversify more easily across sectors and regions. They can exploit scale economies, especially important in small developing countries in order to reduce costs and increase outreach. However, inter-linkages between a few institutions can more easily lead to contagion effects. The failure of large financial institutions imposes high costs on the rest of the financial system and the economy; knowing their too-big-to-fail status, these institutions tend to be more aggressive in their risk-taking decisions and hold less capital.
The writer is Officer at the Islami Bank Bangladesh Ltd (Foreign Exchange Department), and can be reached at email: nurul islam soheljec@yahoo.com