Description
This is the more important since competition policy in the financial sector is often already behind that in many other sectors and still a missing part of the financial sector development agenda in many countries.
Competition in the Financial Sector:
Overview of Competition Policies
Stijn Claessens
WP/09/45
© 2009 International Monetary Fund WP/09/45
IMF Working Paper
Research Department
Competition in the Financial Sector: Overview of Competition Policies
Prepared by Stijn Claessens
1
March 2009
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.
As in other sectors, competition in finance matters for allocative, productive and dynamic
efficiency. Theory suggests, however, that unfettered competition is not first best given the special
features of finance. I review these analytics and describe how to assess the degree of competition in
markets for financial services. Existing research shows that the degree of competition greatly varies
across markets, largely driven by barriers to entry and exit. I argue that changes in financial services
industries require updated competition policies and institutional arrangements, but that practices
still fall short. Furthermore, I show that developing countries face some specific competition
challenges.
JEL Classification Numbers:
G10, G18, G28, L1, L5
Keywords:
financial services, competition, competition policy, contestability,
stability, foreign banks, emerging markets
Author’s E-Mail Address:
[email protected]
1
Paper prepared for the G-20 meeting on Competition in the Financial Sector, Bali, February 16-17,
2008. Stijn Claessens is Assistant Director in the Research Department of the IMF, a Professor of
International Finance Policy at the University of Amsterdam, and a Research Fellow at the CEPR. I
would like to thank Thorsten Beck, Jaap Bikker, Giovanni Dell’Ariccia and Luc Laeven for useful
comments and discussions, the discussant, Mario Nakani, participants at the G-20 meeting, participants
at seminars at the IMF Regional Office in Tokyo, the World Trade Organization (Geneva) and Bruegel
(Brussels), and the referees and the editor for useful comments.
2
Contents Page
I. Introduction ............................................................................................................................3
II. Nature and Status of Financial Sector Competition..............................................................5
A. Effects of Competition in the Financial Sector: Theory ...........................................6
Development and Efficiency, Static and Dynamic............................................6
Access to Financial Services..............................................................................6
Stability..............................................................................................................7
B. The Determinants of Competition and Assessing Competition:
Theory and Empirics.............................................................................................7
Theory of the Determinants of Competition......................................................7
Empirical Approaches to Measure Competition................................................8
The Pazar and Rosse Methodology....................................................................9
C. Empirical Approaches to Explain Competition ......................................................11
Other Empirical Regularities ...........................................................................12
Country and Regional Studies .........................................................................12
Cross-country Studies ......................................................................................15
Internationalization ..........................................................................................16
D. Tools to Analyze .....................................................................................................17
E. Current Status ..........................................................................................................19
III. Implication for Competition Policy in the Financial Sector ..............................................19
A. Approaches..............................................................................................................20
B. Institutional Arrangements......................................................................................23
IV. Conclusion.........................................................................................................................26
Tables
1. PR-Measures (H-statistics) of Competitiveness of Banking Systems Around the World.................34
References..............................................................................................................................................27
3
I. INTRODUCTION
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.
In all, this means that competition policy in the financial sector is quite complex and can be hard
to analyze. Empirical research on competition in the financial sector is also still at an early stage.
The evidence nevertheless shows that factors driving competition and competition have been
important aspects of recent financial sector improvements. To date, greater competition have
been achieved by traditional means: removing entry barriers, liberalizing product restrictions,
abolishing restrictive market definitions, eliminating intra-sectoral restrictions, etc. Making in
this way financial systems more open and contestable, i.e., having low barriers to entry and exit,
has generally led to greater product differentiation, lower cost of financial intermediation, more
access to financial services, and enhanced stability. The evidence for these effects is fairly
universal, from the US, EU and other developed countries to many developing countries.
As globalization, technological improvements and de-regulation further progress, the gains of
competition can be expected to become even more wide-spread across and within countries. At
4
the same time, once the easier steps have been taken, policies to achieve effective competition in
all dimensions and balancing the trade-offs between competition and other concerns, become
more challenging. The rapid competitive gains due to the first rounds of liberalization over the
past few decades will be hard to sustain going forward. Complexity will also become greater
going forward as financial services industries evolve, financial markets and products become
more complex and global, and new regulatory and competition policy issues arise. The rapidly
changing world of financial services provision and the many new forms of financial services
provision means all the more that approaches to competition issues need to be adjusted.
This is the more important since competition policy in the financial sector is often already behind
that in many other sectors and still a missing part of the financial sector development agenda in
many countries. Too often, competition is seen as an afterthought, rather than being considered
an essential ingredient of a financial sector development strategy. To assure markets remain and
become even more competitive will require taking into account the special properties of financial
markets, including the existence of many networks in finance. But here the theoretical and
empirical literature is just catching up with changes. And competition policy will become more
difficult institutionally to organize, both within and across countries, yet necessary given the
global dimensions of many financial markets these days. Furthermore, financial systems are
often entrenched, in developing countries especially, including through links between the
financial and real sectors, and odious relationships with the political sector as well, all of which
can make achieving effective competition complex.
Recent events in global financial markets, while too recent to draw firm conclusions, highlight
some issues on which it will be necessary to reflect. The global dimensions of the financial crisis
clearly confirm the need for many policies, whether aimed at stability or at improving marker
functioning, to operate in a consistent manner across jurisdictions, especially for systemically-
important financial institutions and activities. The crisis also makes clear the need for a more
holistic approach to prudential regulation, at both the institutional and macroeconomic level, to
address wider systemic risks. This objective will likely require measures aimed at strengthening
capital and liquidity requirements for individual institutions, avoiding the build-up of systemic
risk across institutions and the economy over time, and improving national and international
resources and financial sector responses to distress.
The financial crisis has also shown the need to strengthen market discipline, addressing key
information gaps and encouraging more robust private governance and risk management
systems. One other lesson the financial crisis calls for is to revisit the institutional infrastructure
for financial services provision, including the role of rating agencies and the need for derivatives
trading to move to more regulated markets. The crisis also confirms the need for competition
policy to adjust and adapt to developments in financial markets. As some have suggested, in the
context of regulatory failures and weaknesses in private market discipline, increased competition
can lead to excessive risk-taking, implying the need for competition policy to consider broader
aspects. When considering these and other changes, the new architecture will need to take into
account the inherent limitations of regulation and supervision, and guards against overregulation.
The paper reviews the state of knowledge on these issues and how competition policy is and
should be organized. It does so in the following manner. Section 2 provides a review of
5
literature, both of the nature and effects of competition in the financial sector as well as of how
to go about measuring competition in general and in the financial sector specifically. The section
discusses, among others, the approaches and methodology used to tests for the degree of
competition in the financial markets of a particular country or market, presents some data on
measures that are starting to be used for assessing financial sector competitiveness, shows how
these measures relate to structural and policy variables, and what tools to use to measure
competition. It also discusses the current state of affairs in competition policy and how changes
in financial services industries underway affect the nature of competition. Section 3 discusses
the implications for competition policy, how to approach it, and how to organize it. In the last
section, the paper present its conclusions, although not many definitive. It does stress, however,
that practices in many countries fall far short of the large need for better competition policy in
the financial sector.
II. NATURE AND STATUS OF FINANCIAL SECTOR COMPETITION
What is special about competition in financial sector? And how does competition matter? The
two questions are closely related and depend in turn on what dimensions one analyzes. For the
purpose of this paper, I consider the links between competition and the following three
dimensions: financial sector development (including the efficiency of financial services
provision); access to financial services for households and firms (i.e., the availability, or lack
thereof, of financial services at reasonable cost and convenience); and financial sector stability
(i.e., the absence of systemic disturbances that have major real sector impact). Under the first
link, development and efficiency, once can consider questions like: with greater competition, is
the system more developed, e.g., is it larger, does it provide better quality financial
products/services, in a static and dynamic way; is it more efficient, i.e., exhibits a lower cost of
financial intermediation, is it less profitable; and is it closer to some competitive benchmark?
Under access, once can consider whether access to financing, particularly for smaller firms and
poorer individuals, but also in general for households, large firms and other agents is improved,
in terms of volume and costs, with greater competition. And in terms of stability, one can
consider whether the banking system has less volatility, fewer financial crises and is generally
more robust and its financial integrity higher with more competition.
I consider what theory predicts on each of the three dimensions, since all are important and there
can be relationships among them, making analyzing any individually not complete.
2
I then
review the current empirical findings on the same dimensions, and some assessment of the
degree of competition in various financial markets. I next review what both theory and empirics
predict on what drives competition in the financial sector. I analyze specifically
internationalization of financial services, which is growing rapidly and which has had an
especially large impact on financial sector competition in many developing countries. Lastly, I
suggest what these theory and empirical findings suggest in terms of what tools should regulators
use for the application of competition policy.
2
For a recent review of the theoretical literature on competition and banking, see Vives 2001.
6
A. Effects of Competition in the Financial Sector: Theory
Development and Efficiency, Static and Dynamic
As a first-order effect, one expects increased competition in the financial sector to lead to lower
costs and enhanced efficiency of financial intermediation, greater product innovation, and
improved quality. Even though financial services have some special properties, the channels are
similar to other industries. In a theoretical model, Besanko and Thakor (1992), for example,
allowing for the fact that financial products are heterogeneous, analyze the allocational
consequences of relaxing entry barriers and find that equilibrium loan rates decline and deposit
interest rates increase, even when allowing for differentiated competition. In turn, by lowering
the costs of financial intermediation, and thus lowering the cost of capital for non-financial firms,
more competitive banking systems lead to higher growth rates. Of course, they are not just
efficiency and costs, but also the incentives of institutions and markets to innovate that are likely
affected by the degree of competition.
Access to Financial Services
As a first-order effect, greater development, lower costs, enhanced efficiency, and a greater and
wider supply resulting from competition will lead to greater access. The relationships between
competition and banking system performance in terms of access to financing are more complex,
however. The theoretical literature has analyzed how access can depend on the franchise value
of financial institutions and how the general degree of competition can negatively or positively
affect access. Market power in banking, for example, may, to a degree, be beneficial for access
to financing (Petersen and Rajan, 1995). With too much competition, banks may be less inclined
to invest in relationship lending (Rajan, 1992). At the same time, because of hold-up problems,
too little competition may tie borrowers too much to an individual institution, making the
borrower less willing to enter a relationship (Petersen and Rajan, 1994; and Boot and Thakor,
2000). More competition can then, even with relationship lending, lead to more access.
The quality of information can interact with the size and structure of the financial system to
affect the degree of access to financial services. Financial system consolidation can lead to a
greater distance and thereby to less lending to more opaque firms such as SMEs. Improvements
in technology and better information that spur consolidation can be offsetting factors, however.
Theory has shown some other complications. Some have highlighted that competition is partly
endogenous as financial institutions invest in technology and relationships (e.g., Hauswald and
Marguez, 2003). Theory has also shown that technological progress lowering production or
distribution costs for financial services providers does not necessarily lead to more or better
access to finance. Models often end up with ambiguous effects of technological innovations,
access to information, and the dynamic pattern of entry and exit on competition, access, stability
and efficiency (e.g., Dell’Ariccia and Marquez, 2004, and Marquez, 2002). Increased
competition can, for example, lead to more access, but also to weaker lending standards, as
observed recently in the sub-prime lending market in the US (Dell’Ariccia, Laeven and Igan,
2008) but also in other episodes.
These effects are further complicated by the fact that network effects exist in many aspects of
supply, demand or distribution of financial services. In financial services production, much used
7
is made of information networks (e.g., credit bureaus). In distribution, networks are also
extensively used (e.g., use of ATMs). Furthermore, in their consumption, many financial services
display network properties (e.g., liquidity in stock exchanges). As for other network industries,
this makes competition complex (see further Ausubel, 1991, and Claessens, Dobos, Klingebiel
and Laeven, 2003).
Stability
The relationships between competition and stability are also not obvious. Many academics and
especially policy makers have stressed the importance of franchise value for banks in
maintaining incentives for prudent behavior. This in turn has led banking regulators to carefully
balance entry and exit. Licensing, for example, is in part used as a prudential policy, but often
with little regard for its impact on competition. This has often been a static view, however.
Perotti and Suarez (2002) show in a formal model that the behavior of banks today will be
affected by both current and future market structure and the degree to which authorities will
allow for a contestable, i.e., open, system in the future. In such a dynamic model, current
concentration does not necessarily reduce risky lending, but an expected increase in future
market concentration can make banks choose to pursue safer lending today. More generally,
there may not be a tradeoff between stability and increased competition as shown among others
by Allen and Gale (2004), Boyd and De Nicolò (2005) and reviewed recently by Allen and Gale
(2007). Allen and Gale (2004) furthermore show that financial crises, possibly related to the
degree of competition, are not necessarily harmful for growth.
B. The Determinants of Competition and Assessing Competition: Theory and Empirics
I first review as what theory predicts drives competition, in general and specifically in the
financial sector, and then what theory suggests on how best to measure competition and what
tools can be used.
Theory of the Determinants of Competition
In terms of empirical measurement and associated factors driving competition one can consider
three types of approaches: market structure and associated indicators; contestability and
regulatory indicators to gauge contestability; and formal competition measures. Much attention
in policy context and empirical tests is given to market structure and the actual degree of entry
and exit in particular markets as determining the degree of competition. The general Structure-
Conduct-Performance (SCP) paradigm, the dominant paradigm in industrial organization from
1950 till the 1970s, made links between structure and performance. Structure refers to market
structure defined mainly by the concentration in the market. Conduct refers to the behavior of
firms—competitive or collusive—in various dimensions (pricing, R&D, advertising, production,
choice of technology, entry barriers, predation, etc.). And Performance refers to (social)
efficiency, mainly defined by extent of market power, with greater market power implying lower
efficiency. The paradigm was based on the hypotheses that i) Structure influences Conduct (e.g.,
lower concentration leads to more competitive the behavior of firms); ii) Conduct influences
Performance (e.g., more competitive behavior leads to less market power and greater social
8
efficiency). And iii) Structure therefore influences Performance (e.g., lower concentration leads
to lower market power).
3
Theoretically and empirically there are a number of problems with the SCP-paradigm and its
implications that, directly and indirectly, structure determines performance. For one, structure is
not (necessarily) exogenous since market structure itself is affected by firms’ conduct and hence
by performance. Another conceptual problem is that industries with rapid technological
innovation and much creative destruction, likely the financial sector, may have high
concentration and market power, but this is necessary to compensate these firms for their
innovation and investment and does not mean reduced social welfare. Most importantly, and
different from the SCP-paradigm, the more general competition and contestability theory
suggests that market structure and actual degree of entry or exit are not necessarily the most
important factors in determining competition. The degree of contestability, that is, the degree of
absence of entry and exit barriers, rather than actual entry, matters for competitiveness (Baumol,
Panzar, and Willig, 1982). Contestable markets are characterized by operating under the threat of
entry. If a firm in a market with no entry or exit barriers raises its prices above marginal cost and
begins to earn abnormal profits, potential rivals will enter the market to take advantage of these
profits. When the incumbent firm(s) respond(s) by returning prices to levels consistent with
normal profits, the new firms will exit. In this manner, even a single-firm market can show
highly competitive behavior.
The theory of contestable markets has also drawn attention to the fact that there are several sets
of conditions that can yield competitive outcomes, with competitive outcomes possible even in
concentrated systems since it does not mean that the firm is harming consumers by earning
super-normal profits. On the other hand, collusive actions can be sustained even in the presence
of many firms. The applicability of the contestability theory to specific situations can vary,
however, particularly as there are very few markets which are completely free of sunk costs and
entry and exit barriers. Financial sector specific theory adds to this some specific considerations.
While the threat of entry or exit can also be an important determinant of the behavior of financial
market participants, issues such as information asymmetries, investment in relationships, the role
of technology, networks, prudential concerns, and other factors can matter as well for
determining the effective degree of competition (see further Bikker and Spierdijk, 2008).
Empirical Approaches to Measure Competition
There are three approaches that have been proposed for measuring competition. The first
empirical approach considers factors such as financial system concentration, the number of
banks, or Herfindahl indices. It relies on the SCP paradigm, i.e., there being relationships
between structure-conduct-performance, but does not directly gauge banks’ behavior. The
second considers regulatory indicators to gauge the degree of contestability. It takes into account
entry requirements, formal and informal barriers to entry for domestic and foreign banks, activity
3
Within this general paradigm, many aspects have been investigated. For example, there exist studies of the degree
to which firms deviate from a production-efficient frontier, so-called x-inefficiency (see Berger and Humphrey,
1997, for an international survey of x-inefficiency studies for financial institutions).
9
restrictions etc. It also considers changes over time in financial instruments, innovations, etc. as
these can lead to changes in the competitive landscape. The third set uses formal competition
measures, such as the so-called H-statistics, that proxies the reaction of output to input prices.
These formal competition measures are theoretical well-motivated, and have often been used in
other industries, but they do impose assumptions on (financial intermediaries’) cost and
production functions.
In terms of the first two approaches, theory has made clear that documenting an industry’s
structure, the degree of competition, its determinants, and its impacts can be complicated. For
one, the competitiveness of an industry cannot be measured by market structure indicators alone,
such as number of institutions or concentration indexes. And no specific market concentration
measure is best: neither the number of firms, nor the market share of the top 3 or 5, or the often
used Herfindahl index is necessarily the best. Second, traditional performance measures used in
finance, such as the size of banks’ net interest margins or profitability or transaction costs in
stock markets, do not necessarily indicate the competitiveness of a financial system. These
performance measures are also influenced by a number of factors, such as a country’s macro-
performance and stability, the form and degree of taxation of financial intermediation, the quality
of country’s information and judicial systems, and financial institution specific factors, such as
leverage, the scale of operations and risk preferences. As such, these measures can be poor
indicators of the degree of competition. Yet, they have often been so used as such in spite of
these weaknesses. Fortunately, general structure and performance measures have declined in
empirical studies in favor of more specific tests.
Indeed, the third approach emphasizing that documenting the degree of competition requires
specific measures and techniques has become more used. It points out that one needs to study
actual behavior—in terms of marginal revenue, pass-through cost pricing, etc.—using a model
and develop from there a specific measure of competitiveness. While such theoretical well-
founded tests have been conducted for many industries, it, particularly cross-country, was at an
early stage a decade or so ago for the financial sector (see Cetorelli, 1999). More and more,
however, formal empirical tests for competition are being applied to the financial sector, mostly
to banking systems in individual countries (see Bikker and Spierdjik 2008 for a review). Data
problems were previously a hindrance for the cross-country research—since little bank-level data
were available outside of the main developed countries, but recently established databases have
also allowed for better empirical work comparing countries.
The Pazar and Rosse Methodology
Generally, as in other sectors, the degree of competition is measured with respect to the actual
behavior of (marginal) bank conduct. Broad cross-country studies using formal methodologies
are Claessens and Laeven (2004) and Bikker and Spierdijk (2007). Using bank-level data and
applying the Panzar and Rosse (1987; PR) methodology, the first study estimates the degree of
competition in 50 countries’ banking systems. Specifically, it investigates the extent to which a
10
change in factor input prices is reflected in (equilibrium) revenues earned by a specific bank.
The PR-model is, as is typical, estimated using pooled samples for each country.
4
Under perfect competition, an increase in input prices raises both marginal costs and total
revenues by the same amount as the rise in costs. Under a monopoly, an increase in input prices
will increase marginal costs, reduce equilibrium output and consequently reduce total revenues.
The PR model provides a measure (“H-statistic”) of the degree of competitiveness of the
industry, which is calculated from reduced form bank revenue equations as the sum of the
elasticities of the total revenue of the banks with respect to the bank’s input prices. The H-
measure is between 0 and 1, with less than 0 being a collusive (joint monopoly) competition, less
than 1 being monopolistic competition and 1 being perfect competition. It can be shown, if the
bank faces a demand with constant elasticity and a Cobb-Douglas technology, that the magnitude
of H can be interpreted as an inverse measure of the degree of monopoly power, or alternatively,
as a measure of the degree of competition.
The second study, Bikker and Spierdijk (2007), also uses the PR-methodology, but allows the
degree of competition to vary over time and covers 101 countries. Table 1 documents by
individual country the measures of the two studies. The H-statistic of Claessens and Laeven
varies generally between 0.60 and 0.80, suggesting that monopolistic competition sometimes
approaching full competition is the best description of the degree of competition. The Bikker and
Spierdijk data show even larger variation in the degree of competitiveness across the larger
sample of countries, possibly due to their estimation technique allowing for time variation.
While there does not appear to be any strong pattern among types of countries, it is interesting
that some of the largest countries (in terms of number of banks and general size of their
economy) have relatively low values for the H-statistics. In both studies, Japan and the US, for
example, have H-statistics less than 0.5. This may in part be due to the more fragmented banking
markets in these countries, where small banks operate in local markets that are less competitive.
Since studies find differences between types of banks, especially in countries with a large
number of banks, such as the US, studying all banks may lead to a distorted measure of the
4
Specifically, the model to estimate the H-statistics for banking is:
it
it it it
it it it it
D
Y Y Y
W W W P
? ?
? ? ?
? ? ? ?
+ +
+ + + +
+ + + + =
) ln( ) ln( ) ln(
) ln( ) ln( ) ln( ) ln(
, 3 3 , 2 2 , 1 1
, 3 3 , 2 2 , 1 1
where
it
P is the ratio of gross interest revenue to total assets (proxy for output price of loans),
it
W
, 1
is the ratio of
interest expenses to total deposits and money market funding (proxy for input price of deposits),
it
W
, 2
is the ratio of
personnel expense to total assets (proxy for input price of labor),
it
W
, 3
is the ratio of other operating and
administrative expense to total assets (proxy for input price of equipment/fixed capital). The subscript i denotes bank
i, and the subscript t denotes year t.
11
overall competitiveness of a banking system.
5
However, even if one computes H-statistics using
data on large banks, rather than all banks for countries with many banks, results remain similar.
Other papers that use this methodology mostly also reject both perfect collusion as well as
perfect competition, i.e., they find mostly evidence of monopolistic competition (e.g., Wong,
Wong, Fong and Choi, 2006 for Hong Kong; Gutiérrez de Rozas, 2007 for Spain; Hempell, 2002
for Germany; Bikker and Haaf, 2001 summarize the results of some ten studies; Berger, 2000,
further reviews). Tests for emerging markets are rarer, but those done (e.g., Nakane, 2001, for
Brazil; Prasad and Ghosh 2005, for India; Yildirim and Philippatos 2007 for a sample of Latin
America countries) also find evidence of monopolistic competition. There remain large
variations across countries, however, and the ability to capture the degree of competition is still
imperfect, as estimates vary considerably among studies for the same banking systems (Bikker,
Spierdijk, and Finnie, 2006, review a number of studies). This is also clear from Table 1 since
there can be large differences between the two measures reported for individual countries (the
correlation is only 0.38, and the rank correlation only 0.29), showing some of the difficulty in
measuring competitiveness.
C. Empirical Approaches to Explain Competition
Fewer studies have tried to explain the degree of competition in particular markets. Claessens
and Laeven (2004) relate competitiveness (the H-measure) to indicators of countries’ banking
system structures and regulatory regimes. Importantly, and consistent with some other studies,
they find no evidence that their competitiveness measure negatively relates to banking system
concentration or the number of banks in the market. They do find systems with greater foreign
bank entry, and fewer entry and activity restrictions to be more competitive. Their findings
suggest that measures of market structures do not necessarily translate into effective competition,
consistent with the theory that contestability rather than market structure determines effective
competition. Others have studied the impact of financial liberalization on the degree of
competitiveness and find generally that liberalized systems are more competitive, in the sense of
having a higher H-measure.
There are some identification issues here, of course. Just like in studies finding that trade
openness raises efficiency in sectors open to foreign competition, it could be that more efficient
banking sectors are more likely to allow (external) competition, so that efficiency is the cause,
rather than just an effect, of contestability. And there can be omitted variables, as when financial
deregulation is adopted along with other efficiency-enhancing measures. Also, there can be
political economy arguments creating reverse causality or omitted factors—for example, when
insiders prefer closed, but inefficient financial systems. It means that studies assessing the impact
of openness on financial system and aggregate economic performance may have a hard time
identifying the direction of causality and disentangling the effects of financial reforms from
5
For example, De Bandt and Davis (2000) find monopoly behavior for small banks in France and Germany, and
monopolistic competition for small banks in Italy and large banks in all three countries. This suggests that in these
countries, small banks have more market power, perhaps as they cater more to local markets.
12
those of other measures. These caveats apply to most of the financial liberalization and reform
analyses, including those referred to here.
Other Empirical Regularities
There is a broad literature that has documented many empirical regularities between financial
system performance and structural factors within and across countries. This literature has related
actual financial markets behavior to factors deemed to be related to competition, including not
only structure, but also entry barriers, including on foreign ownership, and the severity of
activity restrictions, since those can limit intra-industry competition. Especially for banking
systems, a number of empirical studies have found that the ownership of the entrants and
incumbents, and the size and the degree of financial conglomeration (that is, the mixture of
banking and other forms of financial services, such as insurance and investment banking) matter
in a number of ways.
Many of these studies, however, do not use a structural, contestability approach to measure the
actual degree of competitive conduct and as such can not indicate whether the underlying
behavior is based on competitive or say oligopolistic behavior. Furthermore, often the focus has
been on the banking system only, neglecting other forms of financial intermediation that have
become more important directly in financial intermediation (capital markets, non-bank financial
institutions, insurance companies) or that play a role in determining banking system
competitiveness. Nevertheless, this literature suggests that the degree of competition has
consequences for financial sector performance and sheds some light on competition issues. It can
be classified in individual country and regional studies, cross-country studies, and studies on the
specific effects of internationalization.
Country and Regional Studies
Evidence of competition to matter is most convincingly available from liberalization steps, i.e.,
when reform “unambiguously” introduced more competition. This has notably been the case in
the US with the abolishment of restrictions on intra- and inter-state banking. Strahan (2003), a
major contributor himself, reviews this large literature and notes how it has been able to
document large real effects of US branching deregulation.
6
Besides documenting cross-sectional
regularities, many studies have investigated the effects of changes in structure and especially
consolidation in financial systems. (For an early review, see Berger, Demsetz and Strahan,
1999). Similar experiences have been documented for the EU following the Single Banking
Directives and other measures aimed at creating a more integrated and competitive financial
markets (see for example, CEPR 2005, for a review). And for most emerging markets similar
effects have been documented (see BIS, 2006, for a collection of country experiences).
6
He summaries it as follows: “This paper focuses on how one dimension of this broad-based deregulation—the
removal of limits on bank entry and expansion—affected economic performance. In a nutshell, the results suggest
that this regulatory change was followed by better performance of the real economy. State economies grew faster
and had higher rates of new business formation after this deregulation. At the same time, macroeconomic stability
improved. By opening up markets and allowing the banking system to integrate across the nation, deregulation made
local economies less sensitive to the fortunes of their local banks.”
13
These experiences have also highlighted the symbiotic relationships between increased
competition and changes in regulation: as competition intensifies, regulators are forced to
evaluate remaining rules by markets participants, leading to more focused rules. Foreign banks
have especially been found to stimulate improvements in the quality of local regulation and
supervision (Levine, 1996). As such, foreign bank entry and other forms of international
financial liberalization need not necessarily wait until the local institutional environment is fully
developed. And greater competition can highlight deficiencies that raise the costs of financial
intermediation or hinder access to financial services, and as such be an impetus to reform.
There have thus been large and rapid competitive gains in developed countries due to intra-
country and regional deregulation, and much progress in developing countries’ financial systems
that opened up and experienced large entry, especially in Central and Eastern Europe and Latin
America. Experiences have also shown, however, that gains will be hard to maintain in the
future, largely as it involved the easy steps of liberalization and opening up. The tasks now are to
deepen the competitive impact of liberalization. In most countries, major gains have come first
and foremost to the wholesale capital and corporate finance markets. And even this has been
with some limits since the competitive effects, even after eliminating barriers can remain limited
to some wholesale markets, regions or segments. Even without (many) formal barriers,
competition in many other markets remains imperfect and the gains from competition can be
limited to certain financial services (segments).
Extending the gains to other types of consumers of financial services has not proven easy. Even
in the most developed countries, with good financial institutions and solid institutional
infrastructures, the degree of effective competition in consumer and retail services still lags that
in other financial services segments. In the EMU, for example, following the Euro introduction,
retail deposit and mortgage interest rates have converged—beyond what was due to the
elimination of exchange rate risk, but other financial services still show large price and cost
differences (CEPR, 2005). Indeed in the EU, there remain very large differences in the cost of a
typical basket of retail banking services. The World Retail Banking Report (2005), for example,
estimate that for 19 countries in Europe, North America, Eastern Europe, and the Far East the
cost of a basket varied from €34 to €252, a 1-to-7.4 range, with the high and the low being two
EMU-countries. And beyond the traditional loan and deposit services, many wholesale products
still show large price differences, possibly due to imperfect competition.
7
Similar analysis for developing countries (Beck et al. 2008) shows even larger differences,
especially when scaled by income level. They show, for example, that over 700 dollars are
required to open a bank account in Cameroon, an amount higher than the GDP per capita of that
country. And they highlight that the annual costs to maintain an account in developing countries
can amount to as much as 7% of GDP per capita. While not due to lack of competition alone,
they do find that barriers are higher in countries where there are more stringent restrictions on
7
Even within fully integrated whole-sale markets (no currency risks, limited legal and regulatory differences, good
information, etc.), such as the U.S. and increasingly the EU/EMU, there still is, for example, a familiarity bias, e.g.,
more investment and entry closer to the home of the investor.
14
bank activities and entry, when banking systems are predominantly government-owned, whereas
more foreign bank participation is associated with lower barriers.
Many countries have given improving competition in these segments therefore a greater priority
(e.g., the Financial Sector Action Plan 2005-2010 of the European Commission launched in
2005; the UK following the 2001 Cruickshank report). This has shown that to further facilitate
competition it is not just a matter of opening up or liberalizing more, but rather that many
(subtle) barriers still need to be removed. The Cruickshank report in the UK showed that the
barriers to lowering costs for consumers and SMEs are often subtle, involving combinations of
high costs of switching bank accounts, hidden fees, and limited transparency. The 2007 EU
extensive competition inquiry in retail banking found a number of competition concerns in the
markets for payment cards, payment systems and retail banking products, with barriers not easy
to eliminate. The recent poor experience with sub-prime lending in the US, although mostly an
issue of lack of consumer protection and failure to conduct proper regulation and supervision,
has brought to the fore as well how unfettered competition does not prevent misuse and poor
outcomes.
Experiences have also brought some risks to light. Increased competition can have adverse
effects on access to financial services, as it can undermine the incentives of banks to invest in
information acquisition and thereby lower their lending to information-intensive borrowers.
More generally, more formal lending arrangements often associated with consolidation,
increased distance between lenders and borrowers, greater foreign bank entry, greater use of
technology and more competition—as has happened in many markets—may in theory have
adverse impact on access for some classes of borrowers. There is indeed evidence for the US, EU
and some emerging markets that consolidation has led to a greater distance and thereby to less
lending to more opaque SMEs (Berger, Miller, Petersen, Rajan and Stein, 2005; Carow, Kane
and Marayaman 2004, Karceski, Ongena and Smith 2005, Sapienza 2002, Degryse, Masschelein
and Mitchell, 2005; Boot and Schmeits, 2005 review this literature).
Evidence of this happening on a large scale in developed countries has been limited though and
there have been clearly offsetting trends as well.
8
But for developing countries and emerging
markets especially, these risks may be higher. Due to institutional weaknesses, including poor
information and institutional infrastructure and weak contracting environment, and more general
higher degrees of inequality, the access of SMEs and households in developing countries is often
already less than desirable. In these markets, the possibility exists of bifurcated markets: large
(international) banks may concentrate on large corporations, serving them using domestic and
international platforms with a wide variety of products; and on consumers, providing them with
financial services based on advanced scoring techniques and the like. The left out, middle
segment under such a scenario could be the SMEs. As competition intensifies, profitability may
go down and banks may have little incentives to invest in longer-term, relationships-based
8
In part due to technology, banks are better able today to combine soft and hard information in efficient manners,
and some banks have become very profitable specializing in SME-lending. Also, larger multiple-service banks can
have a comparative advantage in offering a wide range of products and services on a large scale, through the use of
new technologies, business models, and risk management systems, making them effective in the SME markets.
15
lending and information collection necessary for lending to this segment (for a model along these
lines, see Sengupta, 2007).
Improving access and promoting financial inclusion can therefore require some specific
measures, not just complementary to those increasing competition, but partly to offset possible
negative effects of competition. Whether improvements in the information institutional
infrastructure and the contracting environment can compensate fast enough, such that SMEs and
the like (still) have sufficient access to financial services, is an open question. Empirical
evidence on this has been limited to date, but early evidence is positive (see de la Torre, Soledad
Martínez Pería, and Schmukler, 2008).
Cross-country Studies
A number of recent papers have investigated across countries the effects on financial sector
performance of (changes in) financial regulations and specific structural or other factors relating
to how competitive the environment is. Factors analyzed include entry and exit barriers, activity
restrictions, limits on information sharing, and other barriers. Here the empirical findings are
fairly clear. In terms of development and efficiency, deregulation leading to increased
competition has led to lower costs of capital for borrowers and higher rates of return for lenders,
i.e., lower margins and lower costs of financial intermediation, spurring growth. Barth, Caprio
and Levine (2001) document for 107 countries various regulations in place in 1999 on
commercial banks, including various entry and exit restrictions and practices. Using this data,
Barth, Caprio and Levine (2003) show, among others, that tighter entry requirements are
negatively linked with bank efficiency, leading to higher interest rate margins and overhead
expenditures. These results are consistent with both tighter entry restrictions limiting competition
and the contestability of a market determining bank efficiency.
Using bank-level data for 77 countries, Demirgüç-Kunt, Laeven, and Levine (2004) find that
bank concentration, which as noted needs not proxy for the degree of competition, has a negative
effect on banking system efficiency, except in rich countries with well-developed financial
systems and more economic freedoms. Furthermore, limiting entry of new banks and implicit
and explicit restrictions on bank activities are associated with higher bank margins. The fact that
too much competition can undermine stability and lead to financial crises has been often argued
(see Allen and Gale, 2004 for a review), however, has been difficult to document systematically
(for example, Beck, Dermirguc-Kunt and Levine, 2002).
9
Finally, since overall growth combines
a number of aspects—efficiency, access and stability—the relationship between competition in
the financial sector and growth can be insightful. Claessens and Laeven (2005) relate their
competition measure to industrial growth in 16 banking systems. They find that greater
competition in countries’ banking systems allows financially dependent industries to grow faster,
thus providing comprehensive evidence that more competition in the financial sector serves the
broader economy well.
9
Boyd, De Nicolo and Jalal (2006) find for the US no trade-off between bank competition and stability, and that
bank competition fosters the willingness of banks to lend. See also ?ihák, Schaeck, and Wolfe (2006) and ?ihák and
Schaeck (2007).
16
Internationalization
There is also much evidence on the competitive effects of international openness and capital
account liberalization, particularly relevant for developing countries. Overall, the competitive
effects of cross-border capital flows have been found to be generally favorable. In terms of
development and efficiency, competition through cross-border capital flows has been shown to
lead to lower cost of capital for borrowers and higher (risk-adjusted) rates of return for lenders.
Evidence has shown that opening up internationally can spur growth, including through
improved financial intermediation (Bekaert, Harvey and Lundblad, 2005, and Henry 2006 review
this literature; Claessens 2006 reviews the competitive effects of cross-border banking).
Greater cross-border capital flows have been found, though, to increase access more for selected
groups of borrowers, e.g., large corporations that already had preferential access, especially in
developing countries. Tressel and Verdier (2007) find that in countries with weaker overall
governance, politically connected firms benefit relatively more from international financial
integration than other firms do. The growth benefits are consequently not always there. Kose et
al. (2008) highlight the need for a minimum set of initial conditions—good macro-economic
policies, financial and institutional development—for countries to benefit from financial
globalization. And while the effects on stability have generally been found to be favorable?as
international financial integration allows for greater international specialization and
diversification, international capital flows can add to risks, among others, through contagion and
greater risk of financial crises (IMF, 2007).
Foreign bank entry can be an alternative to cross-border capital flows to reach a market. The
entry of foreign banks has been found to have generally favorable competitive effects on the
development and efficiency of domestic, host banking systems (Chopra, 2007 provides an
extensive review of the literature). These generally positive results have occurred through
various channels, resulting from both direct financial intermediation and from competitive
pressures being put on existing banks. There is little evidence of increased volatility associated
with foreign bank entry; rather risks seem to be diversified better. Barth, Caprio and Levine
(2003) show, for example, that allowing foreign bank participation tends to reduce bank fragility.
The qualitative aspects of competitive foreign bank entry—new and better products—have by
nature been harder to document, but have possibly been most important.
The effects of entry of foreign banks have been found, though, to depend on some conditions,
and in some cases there can be negative consequences. Detragiache, Poonam, and Tressel,
(forthcoming) find that foreign bank entry in poor countries is associated with lower (growth in)
private credit. Beck and Soledad Martinez Peria (2007) find contrasting patterns for different
classes of borrowers for Mexico (see also Schulz, 2006 which reviews foreign bank entry in
Mexico). More generally, while evidence of immiserizing effects of internationalization is
limited, achieving the full gains from entry often requires some (minimal) convergence of
regulations, legal and other institutional infrastructure. Furthermore, interactions between capital
account liberalization, financial services liberalization and domestic deregulation can affect the
gains.
Complexity is, however, increasingly due to the changing nature of financial services provision.
Financial services industries are continuously changing, not just due to the removal of barriers
and increased role of non-bank financial institutions, but also due to increased globalization and
17
technological progress, which are all affecting the degree and type of competition. Even in
market segments where competition has been intense and benefits in terms in access and costs
have been very favorable, such as wholesale and capital markets, new competition policy
challenges has arisen, nationally and internationally. The consolidation of financial services
industries, the emergence of large, global players, the large investments in information
technology and brand names necessary to operate effectively and to gain scale, and the presence
of large sunk costs make it difficult to assure full competition, even abstracting from the special
characteristics of financial services. The increased importance of networks is also affecting the
nature and degree of competition. As such, the positive experiences documented here may not
prevail unless policies adjust as well.
D. Tools to Analyze
The literature reviewed makes clear that the tools used by policy makers for identifying and
addressing competition issues in the financial sector need to be specific. It is also clear that tools
will need to be adjusted in light of changes in financial services industries. Measures typically
used to date for measuring lack of competition (e.g., Herfindahl or concentration indexes of
banks or branches within a geographic area) are clearly quite limited, even a few decades ago
and are now even more so given changes in financial services industries. For example, rigid rules
and guidelines, e.g., certain cutoffs for Herfindahl or concentration indexes, will not suffice.
Rather, it is necessary to rely on solid analyses of degree of competitive behavior. Yet, this ends
up being especially complicated since the more sophisticated analytical and empirical tools
developed for measuring competition in other industries are hard to apply to financial services
industries. The unclear production function for financial services, the tendency to produce and
sell bundles of services, the weaker and more volatile data, the presence of network properties,
etc. make assessing the degree of competitive behavior complex. A few examples illustrate the
difficulties.
To measure effectively using the tools from the traditional industrial organization literature (such
as pass-through coefficients) (changes in) competition in banking, the most traditional financial
service for which much data is available, is already complex. Data are often limited and span few
observations. Most tests require at least 50 bank-year observations. Since in many developing
countries the number of banks with good financial information is low, one cannot conduct year-
by-year estimates of the degree of competition, or only subject to large confidence intervals,
making comparisons over time hard. Using data from a larger sample of countries, e.g., all Latin
American countries or EU-15, creates other difficulties, such as comparability.
Networks are another complication that can give rise to special competition measurement issues.
Financial services provision involves the use of an ever greater number of networks, such as
payments, distribution and information systems. This means barriers to entry can arise due to a
lack of access for some financial services providers to essential services. In banking, for
example, network barriers can be closely related to which financial institutions have access to the
payments system, typically banks only. ATM and other distribution networks can further be
limited to banks, or only be available at higher costs to non-bank financial institutions. Obvious
network effects arise when some banks have large nation–wide coverage in branches or ATMs,
as it can allow them to service costumers more cheaply.
18
A recent development in developing countries especially is banking through networks of agents,
where say retail chains with large network of stores serve as correspondent agents for banks
(examples include Bolivia, Brazil, Colombia, India, Mexico, Pakistan, Peru, and South Africa:
see further Mas and Siedek, 2008). This links competition in the retail sector with that in the
financial sector. Also, two-sided networks effects exist in payment cards markets, since larger
point-of-sale (POS) networks are more valuable to both cardholders and merchants. This leads to
complex measurement issues, for which the credit card industries provide an interesting example
(see Pindyck 2007).
Another example of a network is that access to credit and other information on borrowers and
other clients is often limited to (a subset of) incumbent banks. In addition, network
externalities?especially in capital markets, e.g., the agglomeration effects of liquidity?can
complicate the application of competition policy. Ownership and governance structures can play
a role as well. In many stock exchanges, derivatives and other formal trading markets,
ownership and governance structures are changing from mutual to for profit ownership and with
fewer owners. This can make traditional means of ensuring competition work poorly, or at least,
differently,
10
and new competition approaches can be required. There are also forces towards
vertical integration, especially in capital markets (e.g., the integration of trading systems with
clearing and settlement), while other forces push towards more separation in other aspects (e.g.,
clarity in functions) or horizontal consolidation (e.g., economies of scale). Each of these raises
(new) forms of possible anti-competitive behavior.
An example of the complexity in defining a market is payments services. In payments services,
as in many other financial services these days, the issue arises what constitutes the relevant
product market. Payment cards include credit cards, debit cards and charge (or stored value)
cards. While different in terms of underlying technology, pricing schemes and some auxiliary
services, these cards are similar in their cash substitute function, in which case competition
analysis should cover all type of cards. Alternatively, however, payment cards can be seen as
part of a bundle of different services like ATM cash withdrawal, payment service at point-of-sale
(POS) terminals, etc. In which case, payment cards should be analyzed as part of the competition
in bundles of household financial services, including deposit services. This issue is relevant not
just in developed countries, but also in developing countries where cards are rapidly becoming
substitute to traditional banking services. For example, in some markets cards with pre-paid
balances have been introduced that can be used for (small) payments without the need for a bank
account. These and others forms of branchless banking (e.g., mobile banking using phones, see
Ivatury and Mas, 2008) introduce new competition issues.
An example from the capital markets is the increasing trend toward internalization of trading
within financial institutions, institutional investors and other financial intermediaries. While this
can save transactions costs for the final consumer, it makes for less overall transparency and can
lead to anti-competitive outcomes. Yet, data are more difficult to obtain and analysis to establish
anti-competitive behavior is more complex.
10
For example, a private provider of an essential service will have different incentives to serve all in need than a
mutual owned provider where all uses are also members/owners
19
In addition to these complications, market and product definitions have become (more) difficult.
It is somewhat trite, but nevertheless very important from a competition policy point of view to
state that many financial markets today are global in nature, making any application of
competition policy to national markets only of lesser value than in the past. In addition, the
definition of a specific financial service (and its market) has become more difficult. Today, for
example, there are fewer differences than in the past between the markets for pension services
and for asset management services; after all, many people can save in both ways and, provided
tax rules are largely harmonized between the two, will do so. And with many non-financial
institutions providing (near) banking and other financial services, the boundary between banks
and non-bank financial institutions has become more blurred.
E. Current Status
The upshot of these complications and changes in financial services industries is that, for a same
degree of liberalization, competition may be less assured today than in the past. The increasing
presence of high fixed costs and large sunk costs in the production of whole-sale financial
services, can mean significant first mover and scale advantages, possibly leading to natural
monopoly and market power. Externalities, say in e-finance in the adoption of payments using
mobile phones, can make the adoption of new technologies exhibit critical mass properties. In
consumer finance, switching costs may have increased?for example, because automatic
payments are increasingly linked to one’s specific bank account number. This means in turn that
customers can not and do not easily change provider, leading to more complex competition.
There is indeed some evidence from studies on banking systems that the progress in increasing
competition may have slowed down from the early 2000s on, with even some indications of a
decline in competition in some markets (Bikker and Spierdijk, 2007). The robustness of this
finding is yet to be confirmed, and the exact causes are unclear, and in any case, are likely to be
multiple.
The difficulty to document (changes in) competition with current tools shows that the tools to
measure the (lack of) competition policy in financial services` industries need to be enhanced or
even be newly designed to address new issues and changes. This will often require developing
and applying new, economically fully justified models, which will take time and can be complex.
Short of doing so, however, much can be done. Much information on the competitive structure
can still be discerned by focusing on price setting for specific products or financial functions,
e.g., what are the fees charged for consumer retail products or for processing individual pension
premiums or payments. In addition, more focus can be given to the pricing and availability of
inputs necessary to produce financial services, e.g., do all types of financial institutions have
access on the same basis to the retail payments system? This type of information can also be
better disclosed such that users can act on it.
III. IMPLICATION FOR COMPETITION POLICY IN THE FINANCIAL SECTOR
There was already little analysis of the design and conduct of competition policy in the financial
sector. And the “special nature” of finance, with its emphasis on stability, always meant that
competition policy was considered more complicated in the financial services industry. Changes
in financial services industries create their own set of new competition issues and there are surely
20
no easy answers to how reflect these in policy. As such it is hard to be definitive on how
competition policy should be conducted in the financial sector. What is clear that the two aspects
that have to be considered fresh in competition policy include the approaches and the
institutional arrangements.
A. Approaches
One can think of three possible, and largely complementary approaches to conducting
competition policy. One is assuring that entry/exit rules allow for contestable markets in terms of
financial institutions and products. Two is leveling the playing field across financial services
providers and financial products such that there is effective intra-sectoral competition. And three
is assuring that the institutional environment (payments system, credit bureaus, etc) is
contestable. The first has been the traditional approach and the norm. As analyzed above, it has
been quite effective, and will have to remain the essential cornerstone of competition policy in
the financial sector, as in other sectors. But, as noted, on its own it may have reached its limits.
The second, leveling the playing field, means harmonization (or convergence), both among
financial services providers (banks, insurance companies, pension funds, asset management,
etc.), markets—national, regional and global—and between different, but functionally equivalent
types of products?whether called banking, insurance, or capital markets products.
Harmonization’s goal should be that, within particular markets, products are not regulated
differently depending on what type of financial institution provides the service. And products
that offer the same functionality of service, but may be “labeled” differently, i.e., fall under
different regulatory approaches, need to be treated similarly. Harmonization (or convergence)
includes addressing differences in taxes, capital adequacy requirements, transparency/disclosure,
etc. across sectors and products. This will be useful not just to increase competition, but also to
avoid regulatory arbitrage and to reduce differences in the net overall regulatory burden of
products. The increased creation of complex financial products that straddle various markets and
institutions makes the need for a common regulatory approach all the more necessary.
Harmonization across financial service sectors and products is a long-standing issue. On one
hand, the big barriers across financial service sectors have been removed: only in some countries,
but increasingly less so, are there still (large) regulatory barriers between commercial banks,
investment banks, insurance companies and other financial institutions. The fact that these large
barriers have been removed, however, does not make the issue of harmonization moot since
often many smaller barriers remain. Some differences will be due to some “path dependence;”
for example, some products emerged as insurance products but migrated to becoming savings
products. Others arise from the existence of subtle barriers, e.g., some products may be linked to
the payments system for which access is limited. And others again exist because of linkages with
other economic policies, e.g., tax preferences may be linked to pension products but not to
savings. Furthermore, many financial products come bundled (e.g., a checking account has both
savings, payments and often as well credit?overdraft?functions linked to it), making it hard to
compare regulatory burdens of individual products with each other (e.g., the costs of complying
with Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) may be
assigned to a checking account or may be spread over various products).
21
In all cases, there is a need to go more in depth. Yet, designing an ex-ante approach to perfectly
level the playing field is conceptually and in practice very difficult. The current approach, which
is largely reactive—as producers and consumers are faced with differences, they may approach
the various regulators and appeal for harmonization—has therefore benefits. It has also risks,
however. There can be a race to the bottom as the lowest treatment becomes the norm for all
products. It also opens up the possibility of lobbying for favorable treatments. This can go
counter to the valid reasons for differences in regulatory treatments based on, say, prudential
concerns or consumer protection. A proactive approach by authorities and competition agencies
can therefore still be useful.
This can be complemented by given consumers more information. Better price information and
more disclosure on the costs of various financial services can help consumers identify
uncompetitive products and/or start formal complaints. Many countries have centralized places
where, say, interest rates on deposit and standard loan contracts can be found. Experiences show
though that this remains of limited effectiveness when done alone. Market solutions can greatly
and often more effectively foster competition than government initiatives alone, witness the
many firms offering price comparators. Regardless, and similar to what is needed for assessing
the degree of competition, agencies could require better data on prices and costs at the level of
individual products and make this data available. This would be a very important starting point
for users of financial services that often lack empirical bases.
The third approach, assuring that the institutional environment is contestable, is complex as well.
This would mean that the various inputs required for the production and distribution of financial
services, including network services (for example, payments and check system, credit bureaus,
other networks, etc), need to be available to all interested in using them, be fairly and uniformly
priced, and be efficiently provided. For no part of a specific financial service production and
distribution chain should there be any undue barriers or unfair pricing. These steps are
considered basic requirements in most other network industries, where (private) firms are
producing and delivering services (e.g., phone, other telecommunications, energy, and water),
using common networks (e.g., telecommunication lines, power lines, railroads, pipelines, etc.).
With the often subtle barriers in financial services industries, however, these steps and policy
recommendations to foster more effective competition are not easy. In many markets, policy
actions and recommendations have largely been in the form of putting more pressures on the
financial industry, including by relying on codes of conduct, to reduce extensive barriers,
converge standards, limit collusive practices, and encourage consumer mobility by lowering
switching costs. Some strong general policy intervention can at times be necessary, however, to
force more rapid adjustments, create standardization or remove barriers. Some example illustrate
the benefits of strong actions.
Over the past decade many governments have required various retail payments systems initially
developed by (groups of) individual banks within a nation to be integrated and available to all
consumers. This greatly increased not only the quality of payments services, but also often
lowered costs. The EU recently required charges for financial transfers among Euro-zone
countries to be equal to those for domestic transfers (subject to some conditions), which
illustrates the benefits of strong actions. Another option is mandating easy portability of one’s
22
bank account number, which is being introduced in some EU countries. Mandating by
government rule a level playing field can be equally necessary in capital markets to assure fair
trading and pricing for small as well as large investors. In many markets, traders are required to
always use the best price.
11
Important to assuring a contestable institutional infrastructure in finance will be the formulation
and application of standards, but here policy makers will face trade-offs. As the payments system
examples show, in networks, compatibility of systems is mostly based on standards. Standards
can also help avoid coordination problems in firms’ technology choice, and can help consumers
forecast whether the specific technology will be widespread, leading to reduced uncertainty and
less risk of consumer lock-in, and thereby avoid non-adoption (waiting). In several cases after
the industry agreed on a common standard, the adoption of the good or service indeed increased
sharply. In financial services, one good example has been the Society for Worldwide Interbank
Financial Telecommunication (SWIFT) protocol for transacting international payments
introduced in 1977. At the same time, with standards, users can be forced to make a choice.
Furthermore, joining more than one network is often ruled out by contract. Exclusivity
arrangements can lead to the predominance of a large network, even when more differentiated
networks with more consumer choice could proliferate. Anti-competitive behavior can then
easily follow. Policy makers face then a trade-offs between on one hand encouraging market
development by supporting (a particular) standard(s) and achieving critical mass with the best
technology, versus at the same time stimulating competition and not favoring incumbents.
In these and other areas, competition policy approaches in the financial sector can perhaps learn
from those used in other network industries, many of which have adopted relatively sophisticated
competition policies. For example, in many infrastructure industries, the ownership and/or
management of the network has been separated in recent years from the provision of services to
assure fairer competition. Access policies and pricing of network services are often subject to
government regulatory review. In these other industries, some rules for operating on the network
may be standardized through direct government actions or through self-regulatory agencies
assigned with this task, and not left to the (private sector) operators or owners (alone).
Some of these other network industries have also come to grip with the issue of assuring access
to basic services for a wide class of consumers. Through mechanisms such “universal service
obligations,” uniform price rules for essential inputs in producing services or key outputs,
selected subsidies and other (tax) incentives, policy makers have been able to assure (near)
universal access in these other network industries, at least in the most developed countries.
These models are also being applied in developing countries. These approaches may equally
apply to those financial services with large network properties. For example, in payment
services, standard uniform pricing rules could imposed, similar to uniform rates for certain basic
postal, phone, telecommunications, water or electricity services.
11
In the US, this is embodied in the SEC “order protection rule”: no matter where a customer order is routed, it
should receive the best price that is immediately and automatically available anywhere in the national market
system. This principle promotes competition among individual market centers by ensuring that dominant markets
cannot ignore smaller markets displaying the best price.
23
B. Institutional Arrangements
The institutional arrangements for competition policy often will need to change as well. For one,
competition policy need to be separated more clearly from prudential oversight. Some countries
have already taken competition policy out of the central bank or supervisory authority, but in
many countries the responsibility for competition policy still lies with the prudential authority.
This creates conflict of interests (for a review of the arguments, see Carletti and Hartmann,
2002). Separation does not mean that the prudential authority would have no say in competition:
the prudential authority could have some (veto) rights in any specific decisions or general policy
changes. Furthermore, the competition authority could still rely on analyses by the prudential
authority, say, in case technical expertise is scarce in the competition authority. But clearer
separation does address the conflict of interests' issue that has hindered effective competition
policy in the financial sector.
Second, there is much more need to coordinate better, and preferably bring together, competition
policy functions now often dispersed among various agencies within a country (e.g., separate for
banking and non-bank financial institutions, or with prudential regulators, or among both
specialized and general competition policy agencies). Reducing this dispersion will avoid the
inconsistent application of competition policy across financial institutions and products that are
functionally equivalent. It will also allow for the buildup of skills necessary for proper
competition policy analysis. Of course, in many countries, there is also need to improve the skill
base in the judicial system where competition cases may be finally settled or arbitrated.
It will also be important to consider the interactions between competition policy and consumer
protection policies specific to the financial sector.
This concerns three sets of issues: assuring markets work better for all final consumers—what is
sometimes called assuring a proper business conduct; protecting individual consumers—which
can be considered a narrow version of consumer protection; and assuring consumers obtain the
greatest benefits from financial services provision, for example, through proper information and
education—which makes for an even wider concept of consumer protection. Competition policy
is relevant for all these issues, as both too little and too much competition can hurt consumers
through each of these channels.
The costs and benefits of single versus multiple supervisory agencies have been debated for
some time
12
and no simple answers exist here on the best balance, from the point of view of
financial stability or from the perspective of efficiency of financial services provision. It does
relate, however, to the issues of competition and harmonization across financial services and
financial services providers. Financial sector competition policy design thus has to consider the
organization of the supervisory agencies. The move towards single supervisory authorities across
the world—countries as diverse as Estonia, Kazakhstan, South Korea, Nicaragua, and the UK
12
The issue of consolidated supervision is less debated.
24
have adopted it in the last decade—presumably could help with reducing unnecessary differences
arising from multiple regulatory regimes.
13
Superficially, differences in the degree of de-jure or de-facto harmonization (or lack thereof)
among financial instruments are not obvious between various supervisory regimes. Even where
there is a single supervisory authority, it has not done away with all (or even many) of the
regulatory harmonization issues across sectors or products. Presumably, competitive pressures
from producers and users and the lobbying strength of these constituencies relative to regulators
will be the most important factors driving the (de-facto) reduction in barriers. In that respect, a
more fragmented structure of regulation and supervision may well lead to more de-facto
harmonization and convergence as financial services industries are stronger positioned to argue
for regulatory changes and agencies “compete” with each other.
14
Nevertheless, whether any of
these institutional arrangements are superior from the point of view of efficient financial services
provision has not been researched in depth and may remain unclear in any case given the
difficulty of attribution. And the organization of a supervisory authority in a single country may
be of little relevance when competition for some financial services already is on a global basis.
The changing nature of financial services provision also means that other aspects affect the
competitive environment. For example, the competitive structure in telecommunication markets
may affect the market for electronic (or remote) finance, as in case of mobile payments. And,
obviously, there is a much greater need today for international cooperation among various
national agencies in the application of competition policy. Harmonization and convergence
across markets, already a very complex undertaking within countries, will be compounded
regionally or globally. The EU-experience, which has been engaged for quite some time now in a
process of financial integration and convergence, shows the tenacity needed to create a single
market for financial services. It shows that requiring some uniformity in minimal regulations is
not sufficient since inconsistencies with national rules and laws still arise, as other policy areas
need to be adjusted, which take much time and effort.
These national, regional and global experiences also show how many conceptually difficult
questions can arise with convergence. For example, while many banks operate across borders
without barriers, liquidity support and lender of last resort facilities are still organized nationally.
13
Although there is this trend, it is not general. Some countries have recently adopted the model of integrating
systemic stability and all?banking, insurance and pension?individual financial institutions prudential oversight, in
one agency, but separate from the agency for market conduct supervision. Others have left systemic stability with
the central bank, but organized prudential and market conduct under two separate agencies. Yet others have made
no changes and still have separate prudential banking, securities markets and insurance supervisors operating in one
country (and sometimes multiple of each, e.g., the US).
14
Obviously, this is highly context and country dependent, and ignores many other dimensions. For example, with
strong financial institutions and weak regulators, a greater influence of private interests could lead in some countries
to lax and low-cost standards, with perhaps greater competitiveness, but with more risk of financial instability. In
other environments, capture of the regulator may lead to rent-seeking by (selected) financial institutions, but with
limited risks.
25
This creates inconsistencies with policies for dealing with financial insolvency.
15
While this topic
largely concerns financial stability and is beyond this paper (there is large literature here; see the
papers collected in Caprio, Evanoff and Kaufman, 2006), these differences can also have
competitive implications. For example, banks from some countries may have more generous
access to the local safety net than banks from other countries do. Of course, these issues also
arise within countries, as when state-owned banks attract deposits at low interest rate because
they are (perceived to be) covered more generously by the safety net, as has happened often in
developing countries. And they arise both ex-ante and ex-post, as when weak banks receive
liquidity and/or solvency support.
16
These and other issues mean that competition agencies will
have to be both reactive and proactive in their investigations. Today, agencies often only respond
to events such as large scale mergers and acquisitions, but undertake little analysis of
competitive conditions in existing markets. An approach targeted at key areas of concern of
possible anti-competitive behavior would be useful.
Lastly, harmonization and convergence depend these days to a great extent on international
standards, of which the ones developed by the BCBS, IOSCO, IAIS and CPSS are the most
visible. This has become a large body of “soft law”.
17
The ambition levels of these standards
vary, from suggestions to achieve a minimum common denominator among existing national
requirements, which is most often the case, to going beyond existing national requirements.
Although the standards are voluntary in nature and implementation is left to countries
themselves, some of the standards can be quite intrusive. In most cases, functional convergence
and arbitrage would make remaining cross-border regulatory differences of little consequence in
hindering competition. Some major initiatives, however, like Basel II and other rules affecting
(cross-border) banking may end up hindering effective competition in some respects.
18
15
Although liquidity management may be done centrally by the foreign bank in its home country, branches of
foreign banks are typically eligible to receive liquidity support from the local host central bank. In case of
insolvency of the head bank, however, the home country authorities are responsible, which can involve home
government resources in case the whole bank fails. In single currency regions, like the EMU, there is an additional
need for coordination between member countries’ liquidity support and ECB’s monetary policy.
16
This has happened in many financial crises (see Claessens, Klingebiel and Laeven (2003) for a overview of
measures used in restructuring), but in the past has not led to competitive questions. The recent cases of the
liquidity support for Northern Rock in the UK, the solvency support for IKB in Germany and the “bail-out” of Bear
Stearns, however, have attracted some attention for their potential ant-competitive implications. Also, the (on-
going) large scale liquidity support during the recent financial crisis from the US Federal Reserve Board, the ECB
and the Bank of England could raise such questions.
17
There are issues of the legitimacy and governance of the standards setting bodies, which are not discussed here.
18
The Basel II rules, for example, encourage international banks to use the same risk management approaches
across national jurisdictions, which creates a level playing field and can help with competition. At the same time,
too uniform application could lead credit risks to be priced too rich in some countries (e.g., emerging markets) and
too thin in other countries. Adapting the approaches to capture the risks in various markets appropriately is
necessary, but would negate some of the gains of uniformity.
26
IV. CONCLUSION
I review the state of knowledge on competition in the financial sector and how competition
policy is and should be organized. I show that competition matters as in other industries, but that
there are some specific analytical issues. Notably is the effect of excessive competition on
financial stability, but also that the degree of competition matters for the access of firms and
households to financial services. As a consequence, the view that competition in financial
services is unambiguously good is more naive than in other industries. And it is not sufficient to
analyze competitiveness from a narrow concept alone or focus on one effect only. One has to
consider a broader set of objectives, including efficiency, access to services to various segments
of users, and systemic financial sector stability, and possible tradeoffs among these objective. In
terms of the factors driving competition in the financial sector and empirical measurement of
competition, I highlight that one needs to consider standard industrial organization factors, such
as entry and exit and contestability, but also that financial services provision has many network
properties in production, distribution, and consumption, making for complex competition
structures.
Besides the theoretical complexity, empirical evidence on competition in the financial sector is
scarce and often not (yet) clear. Much of the current literature relates performance indicators to
countries’ financial system structures and regulatory regimes without formal measures of
competitiveness. And the contestability view of competition is not the one typically applied.
Rather, the market structure-conduct-performance paradigm is at best used. What is available,
however, suggests that competition has spurred improvements, including greater product
differentiation, lower cost of financial intermediation, more access to services, and enhanced
stability. This evidence is fairly universal, from developed countries to many developing
countries. In terms of factors driving competition, to date, it has been achieved by traditional
means, i.e., making systems more open and contestable, i.e., having low barriers to entry and
exit, with in developing countries internationalization of financial services often driving changes.
As globalization, technological improvements and de-regulation further progress, the gains of
competition can be expected to become even more wide-spread across and within countries.
At the same time, the review shows that once the easier steps have been taken, policies to
achieve effective competition in all dimensions, and balancing the trade-offs between
competition and other concerns, become more challenging. As financial services industries
evolve, and as financial markets and products become more complex and global, new regulatory
and competition policy issues arise. This means that approaches to competition issues need to
adjust, important since competition policy in the financial sector is often already behind. But the
theoretical and empirical literature is just catching up with the special issues and changes in
financial services industries.
To move forward, therefore, besides improving the measurement of competition, much can be
learned from policies already standard in many other industries, especially network industries. I
make some suggestions on what approaches, as well as institutional arrangements and tools best
fit a modern view of competition policy in the financial sector. I also suggest that policy makers
can greatly enhance available data so that users will have the information needed to assess the
costs of different financial services. Finally, with rapid changing financial services industries,
there is a need to remain agile and adjust competition policies and procedures.
27
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34
Table 1. PR-Measures (H-statistics) of Competitiveness of Banking Systems Around the World
Bikker and Spierdijk Claessens and Laeven
country H (at end of the period) H average
Algeria 0.34
Andorra 0.88
Argentina 0.55 0.73
Armenia 0.43
Australia 0.29 0.8
Austria -0.05 0.66
Azerbaijan 0
Bahamas 0.6
Bahrain 0.41
Bangladesh 0.87 0.69
Belgium 0.73 0.73
Bermuda 0.87
Bolivia 0.99
Botswana 0.23
Brazil 0.55 0.83
Canada 0.2 0.67
Cayman Islands 0.96
Chile 0.93 0.66
China PR 1.57
Colombia 0.78 0.66
Costa Rica 0.78 0.92
Croatia 0.04 0.56
Cyprus -0.09
Czech Republic 0.82 0.73
Denmark 0.27 0.5
Dominican Republic 0.23 0.72
Ecuador 0.67 0.68
El Salvador 0.45
Estonia 0.11
Finland -0.07
France 0.82 0.69
Germany 0.8 0.58
Ghana 0.61
Greece 0.47 0.76
Hong Kong -0.04 0.7
Honduras 0.81
Hungary 0.79 0.75
Iceland 0.55
India 0.49 0.53
Indonesia -0.06 0.62
Ireland 1.12
Israel 0.15
Italy 0.08 0.6
Ivory Coast -0.04
Japan 0.44 0.47
Jordan 0.33
Kazakhstan 0.28
Kenya 0.62 0.58
Korea 1.03
Kuwait 0.36
Latvia 0.52 0.66
35
Bikker and Spierdijk Claessens and Laeven
country H (at end of the period) H average
Lithuania 0.4
Luxembourg 0.37 0.82
Macau 0.23
Macedonia -0.01
Malaysia 0.7 0.68
Malta 0.3
Mauritius 0.58
Mexico 0.37 0.78
Moldova 0.58
Monaco 0.41
Morocco 0.32
Mozambique 0.61
Nepal 0.9
Netherlands 0.92 0.86
New Zealand -0.25
Nigeria 0.74 0.67
Norway 0.5 0.57
Oman 0.35
Pakistan 0.54 0.48
Panama 0.56 0.74
Paraguay 0.75 0.6
Peru 1.37 0.72
Philippines 0.28 0.66
Poland 0.03 0.77
Portugal -0.02 0.67
Romania 0.59
Russian Federation 0.41 0.54
Saudi Arabia 0.51
Senegal 0.18
Singapore 0.51
Slovakia 0.16
Slovenia 0.29
South Africa 2.03 0.85
Spain 0.52 0.53
Sri Lanka 0.67
Sweden -0.08
Switzerland 0.74 0.67
Taiwan 0.94
Thailand 0.63
Trinidad Tobago 0.21
Turkey 0.43 0.46
Ukraine 0.44 0.68
United Arab Emirates 0.46
United Kingdom 0.76 0.74
United States 0.46 0.41
Uruguay 0.53
Venezuela 0.74 0.74
Vietnam 0.74
Zambia 0.53
NOTES: The table displays two measures. The Bikker and Spierdijk measure allows for variation over time and the reported H-
statistic for each country is the one estimated for the end of the sample period. The samples used vary considerable across
countries. The Claessens and Laeven measure is the estimated average H-statistic for each country in their sample calculated for
the years 1994-2001 using the Panzar-Rosse (1987) approach. In their case, the H-statistics are based on a sample that includes
observations from countries with a total number of at least 50 bank-year observations and observations on at least 20 banks.
doc_572716337.pdf
This is the more important since competition policy in the financial sector is often already behind that in many other sectors and still a missing part of the financial sector development agenda in many countries.
Competition in the Financial Sector:
Overview of Competition Policies
Stijn Claessens
WP/09/45
© 2009 International Monetary Fund WP/09/45
IMF Working Paper
Research Department
Competition in the Financial Sector: Overview of Competition Policies
Prepared by Stijn Claessens
1
March 2009
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.
As in other sectors, competition in finance matters for allocative, productive and dynamic
efficiency. Theory suggests, however, that unfettered competition is not first best given the special
features of finance. I review these analytics and describe how to assess the degree of competition in
markets for financial services. Existing research shows that the degree of competition greatly varies
across markets, largely driven by barriers to entry and exit. I argue that changes in financial services
industries require updated competition policies and institutional arrangements, but that practices
still fall short. Furthermore, I show that developing countries face some specific competition
challenges.
JEL Classification Numbers:
G10, G18, G28, L1, L5
Keywords:
financial services, competition, competition policy, contestability,
stability, foreign banks, emerging markets
Author’s E-Mail Address:
[email protected]
1
Paper prepared for the G-20 meeting on Competition in the Financial Sector, Bali, February 16-17,
2008. Stijn Claessens is Assistant Director in the Research Department of the IMF, a Professor of
International Finance Policy at the University of Amsterdam, and a Research Fellow at the CEPR. I
would like to thank Thorsten Beck, Jaap Bikker, Giovanni Dell’Ariccia and Luc Laeven for useful
comments and discussions, the discussant, Mario Nakani, participants at the G-20 meeting, participants
at seminars at the IMF Regional Office in Tokyo, the World Trade Organization (Geneva) and Bruegel
(Brussels), and the referees and the editor for useful comments.
2
Contents Page
I. Introduction ............................................................................................................................3
II. Nature and Status of Financial Sector Competition..............................................................5
A. Effects of Competition in the Financial Sector: Theory ...........................................6
Development and Efficiency, Static and Dynamic............................................6
Access to Financial Services..............................................................................6
Stability..............................................................................................................7
B. The Determinants of Competition and Assessing Competition:
Theory and Empirics.............................................................................................7
Theory of the Determinants of Competition......................................................7
Empirical Approaches to Measure Competition................................................8
The Pazar and Rosse Methodology....................................................................9
C. Empirical Approaches to Explain Competition ......................................................11
Other Empirical Regularities ...........................................................................12
Country and Regional Studies .........................................................................12
Cross-country Studies ......................................................................................15
Internationalization ..........................................................................................16
D. Tools to Analyze .....................................................................................................17
E. Current Status ..........................................................................................................19
III. Implication for Competition Policy in the Financial Sector ..............................................19
A. Approaches..............................................................................................................20
B. Institutional Arrangements......................................................................................23
IV. Conclusion.........................................................................................................................26
Tables
1. PR-Measures (H-statistics) of Competitiveness of Banking Systems Around the World.................34
References..............................................................................................................................................27
3
I. INTRODUCTION
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.
In all, this means that competition policy in the financial sector is quite complex and can be hard
to analyze. Empirical research on competition in the financial sector is also still at an early stage.
The evidence nevertheless shows that factors driving competition and competition have been
important aspects of recent financial sector improvements. To date, greater competition have
been achieved by traditional means: removing entry barriers, liberalizing product restrictions,
abolishing restrictive market definitions, eliminating intra-sectoral restrictions, etc. Making in
this way financial systems more open and contestable, i.e., having low barriers to entry and exit,
has generally led to greater product differentiation, lower cost of financial intermediation, more
access to financial services, and enhanced stability. The evidence for these effects is fairly
universal, from the US, EU and other developed countries to many developing countries.
As globalization, technological improvements and de-regulation further progress, the gains of
competition can be expected to become even more wide-spread across and within countries. At
4
the same time, once the easier steps have been taken, policies to achieve effective competition in
all dimensions and balancing the trade-offs between competition and other concerns, become
more challenging. The rapid competitive gains due to the first rounds of liberalization over the
past few decades will be hard to sustain going forward. Complexity will also become greater
going forward as financial services industries evolve, financial markets and products become
more complex and global, and new regulatory and competition policy issues arise. The rapidly
changing world of financial services provision and the many new forms of financial services
provision means all the more that approaches to competition issues need to be adjusted.
This is the more important since competition policy in the financial sector is often already behind
that in many other sectors and still a missing part of the financial sector development agenda in
many countries. Too often, competition is seen as an afterthought, rather than being considered
an essential ingredient of a financial sector development strategy. To assure markets remain and
become even more competitive will require taking into account the special properties of financial
markets, including the existence of many networks in finance. But here the theoretical and
empirical literature is just catching up with changes. And competition policy will become more
difficult institutionally to organize, both within and across countries, yet necessary given the
global dimensions of many financial markets these days. Furthermore, financial systems are
often entrenched, in developing countries especially, including through links between the
financial and real sectors, and odious relationships with the political sector as well, all of which
can make achieving effective competition complex.
Recent events in global financial markets, while too recent to draw firm conclusions, highlight
some issues on which it will be necessary to reflect. The global dimensions of the financial crisis
clearly confirm the need for many policies, whether aimed at stability or at improving marker
functioning, to operate in a consistent manner across jurisdictions, especially for systemically-
important financial institutions and activities. The crisis also makes clear the need for a more
holistic approach to prudential regulation, at both the institutional and macroeconomic level, to
address wider systemic risks. This objective will likely require measures aimed at strengthening
capital and liquidity requirements for individual institutions, avoiding the build-up of systemic
risk across institutions and the economy over time, and improving national and international
resources and financial sector responses to distress.
The financial crisis has also shown the need to strengthen market discipline, addressing key
information gaps and encouraging more robust private governance and risk management
systems. One other lesson the financial crisis calls for is to revisit the institutional infrastructure
for financial services provision, including the role of rating agencies and the need for derivatives
trading to move to more regulated markets. The crisis also confirms the need for competition
policy to adjust and adapt to developments in financial markets. As some have suggested, in the
context of regulatory failures and weaknesses in private market discipline, increased competition
can lead to excessive risk-taking, implying the need for competition policy to consider broader
aspects. When considering these and other changes, the new architecture will need to take into
account the inherent limitations of regulation and supervision, and guards against overregulation.
The paper reviews the state of knowledge on these issues and how competition policy is and
should be organized. It does so in the following manner. Section 2 provides a review of
5
literature, both of the nature and effects of competition in the financial sector as well as of how
to go about measuring competition in general and in the financial sector specifically. The section
discusses, among others, the approaches and methodology used to tests for the degree of
competition in the financial markets of a particular country or market, presents some data on
measures that are starting to be used for assessing financial sector competitiveness, shows how
these measures relate to structural and policy variables, and what tools to use to measure
competition. It also discusses the current state of affairs in competition policy and how changes
in financial services industries underway affect the nature of competition. Section 3 discusses
the implications for competition policy, how to approach it, and how to organize it. In the last
section, the paper present its conclusions, although not many definitive. It does stress, however,
that practices in many countries fall far short of the large need for better competition policy in
the financial sector.
II. NATURE AND STATUS OF FINANCIAL SECTOR COMPETITION
What is special about competition in financial sector? And how does competition matter? The
two questions are closely related and depend in turn on what dimensions one analyzes. For the
purpose of this paper, I consider the links between competition and the following three
dimensions: financial sector development (including the efficiency of financial services
provision); access to financial services for households and firms (i.e., the availability, or lack
thereof, of financial services at reasonable cost and convenience); and financial sector stability
(i.e., the absence of systemic disturbances that have major real sector impact). Under the first
link, development and efficiency, once can consider questions like: with greater competition, is
the system more developed, e.g., is it larger, does it provide better quality financial
products/services, in a static and dynamic way; is it more efficient, i.e., exhibits a lower cost of
financial intermediation, is it less profitable; and is it closer to some competitive benchmark?
Under access, once can consider whether access to financing, particularly for smaller firms and
poorer individuals, but also in general for households, large firms and other agents is improved,
in terms of volume and costs, with greater competition. And in terms of stability, one can
consider whether the banking system has less volatility, fewer financial crises and is generally
more robust and its financial integrity higher with more competition.
I consider what theory predicts on each of the three dimensions, since all are important and there
can be relationships among them, making analyzing any individually not complete.
2
I then
review the current empirical findings on the same dimensions, and some assessment of the
degree of competition in various financial markets. I next review what both theory and empirics
predict on what drives competition in the financial sector. I analyze specifically
internationalization of financial services, which is growing rapidly and which has had an
especially large impact on financial sector competition in many developing countries. Lastly, I
suggest what these theory and empirical findings suggest in terms of what tools should regulators
use for the application of competition policy.
2
For a recent review of the theoretical literature on competition and banking, see Vives 2001.
6
A. Effects of Competition in the Financial Sector: Theory
Development and Efficiency, Static and Dynamic
As a first-order effect, one expects increased competition in the financial sector to lead to lower
costs and enhanced efficiency of financial intermediation, greater product innovation, and
improved quality. Even though financial services have some special properties, the channels are
similar to other industries. In a theoretical model, Besanko and Thakor (1992), for example,
allowing for the fact that financial products are heterogeneous, analyze the allocational
consequences of relaxing entry barriers and find that equilibrium loan rates decline and deposit
interest rates increase, even when allowing for differentiated competition. In turn, by lowering
the costs of financial intermediation, and thus lowering the cost of capital for non-financial firms,
more competitive banking systems lead to higher growth rates. Of course, they are not just
efficiency and costs, but also the incentives of institutions and markets to innovate that are likely
affected by the degree of competition.
Access to Financial Services
As a first-order effect, greater development, lower costs, enhanced efficiency, and a greater and
wider supply resulting from competition will lead to greater access. The relationships between
competition and banking system performance in terms of access to financing are more complex,
however. The theoretical literature has analyzed how access can depend on the franchise value
of financial institutions and how the general degree of competition can negatively or positively
affect access. Market power in banking, for example, may, to a degree, be beneficial for access
to financing (Petersen and Rajan, 1995). With too much competition, banks may be less inclined
to invest in relationship lending (Rajan, 1992). At the same time, because of hold-up problems,
too little competition may tie borrowers too much to an individual institution, making the
borrower less willing to enter a relationship (Petersen and Rajan, 1994; and Boot and Thakor,
2000). More competition can then, even with relationship lending, lead to more access.
The quality of information can interact with the size and structure of the financial system to
affect the degree of access to financial services. Financial system consolidation can lead to a
greater distance and thereby to less lending to more opaque firms such as SMEs. Improvements
in technology and better information that spur consolidation can be offsetting factors, however.
Theory has shown some other complications. Some have highlighted that competition is partly
endogenous as financial institutions invest in technology and relationships (e.g., Hauswald and
Marguez, 2003). Theory has also shown that technological progress lowering production or
distribution costs for financial services providers does not necessarily lead to more or better
access to finance. Models often end up with ambiguous effects of technological innovations,
access to information, and the dynamic pattern of entry and exit on competition, access, stability
and efficiency (e.g., Dell’Ariccia and Marquez, 2004, and Marquez, 2002). Increased
competition can, for example, lead to more access, but also to weaker lending standards, as
observed recently in the sub-prime lending market in the US (Dell’Ariccia, Laeven and Igan,
2008) but also in other episodes.
These effects are further complicated by the fact that network effects exist in many aspects of
supply, demand or distribution of financial services. In financial services production, much used
7
is made of information networks (e.g., credit bureaus). In distribution, networks are also
extensively used (e.g., use of ATMs). Furthermore, in their consumption, many financial services
display network properties (e.g., liquidity in stock exchanges). As for other network industries,
this makes competition complex (see further Ausubel, 1991, and Claessens, Dobos, Klingebiel
and Laeven, 2003).
Stability
The relationships between competition and stability are also not obvious. Many academics and
especially policy makers have stressed the importance of franchise value for banks in
maintaining incentives for prudent behavior. This in turn has led banking regulators to carefully
balance entry and exit. Licensing, for example, is in part used as a prudential policy, but often
with little regard for its impact on competition. This has often been a static view, however.
Perotti and Suarez (2002) show in a formal model that the behavior of banks today will be
affected by both current and future market structure and the degree to which authorities will
allow for a contestable, i.e., open, system in the future. In such a dynamic model, current
concentration does not necessarily reduce risky lending, but an expected increase in future
market concentration can make banks choose to pursue safer lending today. More generally,
there may not be a tradeoff between stability and increased competition as shown among others
by Allen and Gale (2004), Boyd and De Nicolò (2005) and reviewed recently by Allen and Gale
(2007). Allen and Gale (2004) furthermore show that financial crises, possibly related to the
degree of competition, are not necessarily harmful for growth.
B. The Determinants of Competition and Assessing Competition: Theory and Empirics
I first review as what theory predicts drives competition, in general and specifically in the
financial sector, and then what theory suggests on how best to measure competition and what
tools can be used.
Theory of the Determinants of Competition
In terms of empirical measurement and associated factors driving competition one can consider
three types of approaches: market structure and associated indicators; contestability and
regulatory indicators to gauge contestability; and formal competition measures. Much attention
in policy context and empirical tests is given to market structure and the actual degree of entry
and exit in particular markets as determining the degree of competition. The general Structure-
Conduct-Performance (SCP) paradigm, the dominant paradigm in industrial organization from
1950 till the 1970s, made links between structure and performance. Structure refers to market
structure defined mainly by the concentration in the market. Conduct refers to the behavior of
firms—competitive or collusive—in various dimensions (pricing, R&D, advertising, production,
choice of technology, entry barriers, predation, etc.). And Performance refers to (social)
efficiency, mainly defined by extent of market power, with greater market power implying lower
efficiency. The paradigm was based on the hypotheses that i) Structure influences Conduct (e.g.,
lower concentration leads to more competitive the behavior of firms); ii) Conduct influences
Performance (e.g., more competitive behavior leads to less market power and greater social
8
efficiency). And iii) Structure therefore influences Performance (e.g., lower concentration leads
to lower market power).
3
Theoretically and empirically there are a number of problems with the SCP-paradigm and its
implications that, directly and indirectly, structure determines performance. For one, structure is
not (necessarily) exogenous since market structure itself is affected by firms’ conduct and hence
by performance. Another conceptual problem is that industries with rapid technological
innovation and much creative destruction, likely the financial sector, may have high
concentration and market power, but this is necessary to compensate these firms for their
innovation and investment and does not mean reduced social welfare. Most importantly, and
different from the SCP-paradigm, the more general competition and contestability theory
suggests that market structure and actual degree of entry or exit are not necessarily the most
important factors in determining competition. The degree of contestability, that is, the degree of
absence of entry and exit barriers, rather than actual entry, matters for competitiveness (Baumol,
Panzar, and Willig, 1982). Contestable markets are characterized by operating under the threat of
entry. If a firm in a market with no entry or exit barriers raises its prices above marginal cost and
begins to earn abnormal profits, potential rivals will enter the market to take advantage of these
profits. When the incumbent firm(s) respond(s) by returning prices to levels consistent with
normal profits, the new firms will exit. In this manner, even a single-firm market can show
highly competitive behavior.
The theory of contestable markets has also drawn attention to the fact that there are several sets
of conditions that can yield competitive outcomes, with competitive outcomes possible even in
concentrated systems since it does not mean that the firm is harming consumers by earning
super-normal profits. On the other hand, collusive actions can be sustained even in the presence
of many firms. The applicability of the contestability theory to specific situations can vary,
however, particularly as there are very few markets which are completely free of sunk costs and
entry and exit barriers. Financial sector specific theory adds to this some specific considerations.
While the threat of entry or exit can also be an important determinant of the behavior of financial
market participants, issues such as information asymmetries, investment in relationships, the role
of technology, networks, prudential concerns, and other factors can matter as well for
determining the effective degree of competition (see further Bikker and Spierdijk, 2008).
Empirical Approaches to Measure Competition
There are three approaches that have been proposed for measuring competition. The first
empirical approach considers factors such as financial system concentration, the number of
banks, or Herfindahl indices. It relies on the SCP paradigm, i.e., there being relationships
between structure-conduct-performance, but does not directly gauge banks’ behavior. The
second considers regulatory indicators to gauge the degree of contestability. It takes into account
entry requirements, formal and informal barriers to entry for domestic and foreign banks, activity
3
Within this general paradigm, many aspects have been investigated. For example, there exist studies of the degree
to which firms deviate from a production-efficient frontier, so-called x-inefficiency (see Berger and Humphrey,
1997, for an international survey of x-inefficiency studies for financial institutions).
9
restrictions etc. It also considers changes over time in financial instruments, innovations, etc. as
these can lead to changes in the competitive landscape. The third set uses formal competition
measures, such as the so-called H-statistics, that proxies the reaction of output to input prices.
These formal competition measures are theoretical well-motivated, and have often been used in
other industries, but they do impose assumptions on (financial intermediaries’) cost and
production functions.
In terms of the first two approaches, theory has made clear that documenting an industry’s
structure, the degree of competition, its determinants, and its impacts can be complicated. For
one, the competitiveness of an industry cannot be measured by market structure indicators alone,
such as number of institutions or concentration indexes. And no specific market concentration
measure is best: neither the number of firms, nor the market share of the top 3 or 5, or the often
used Herfindahl index is necessarily the best. Second, traditional performance measures used in
finance, such as the size of banks’ net interest margins or profitability or transaction costs in
stock markets, do not necessarily indicate the competitiveness of a financial system. These
performance measures are also influenced by a number of factors, such as a country’s macro-
performance and stability, the form and degree of taxation of financial intermediation, the quality
of country’s information and judicial systems, and financial institution specific factors, such as
leverage, the scale of operations and risk preferences. As such, these measures can be poor
indicators of the degree of competition. Yet, they have often been so used as such in spite of
these weaknesses. Fortunately, general structure and performance measures have declined in
empirical studies in favor of more specific tests.
Indeed, the third approach emphasizing that documenting the degree of competition requires
specific measures and techniques has become more used. It points out that one needs to study
actual behavior—in terms of marginal revenue, pass-through cost pricing, etc.—using a model
and develop from there a specific measure of competitiveness. While such theoretical well-
founded tests have been conducted for many industries, it, particularly cross-country, was at an
early stage a decade or so ago for the financial sector (see Cetorelli, 1999). More and more,
however, formal empirical tests for competition are being applied to the financial sector, mostly
to banking systems in individual countries (see Bikker and Spierdjik 2008 for a review). Data
problems were previously a hindrance for the cross-country research—since little bank-level data
were available outside of the main developed countries, but recently established databases have
also allowed for better empirical work comparing countries.
The Pazar and Rosse Methodology
Generally, as in other sectors, the degree of competition is measured with respect to the actual
behavior of (marginal) bank conduct. Broad cross-country studies using formal methodologies
are Claessens and Laeven (2004) and Bikker and Spierdijk (2007). Using bank-level data and
applying the Panzar and Rosse (1987; PR) methodology, the first study estimates the degree of
competition in 50 countries’ banking systems. Specifically, it investigates the extent to which a
10
change in factor input prices is reflected in (equilibrium) revenues earned by a specific bank.
The PR-model is, as is typical, estimated using pooled samples for each country.
4
Under perfect competition, an increase in input prices raises both marginal costs and total
revenues by the same amount as the rise in costs. Under a monopoly, an increase in input prices
will increase marginal costs, reduce equilibrium output and consequently reduce total revenues.
The PR model provides a measure (“H-statistic”) of the degree of competitiveness of the
industry, which is calculated from reduced form bank revenue equations as the sum of the
elasticities of the total revenue of the banks with respect to the bank’s input prices. The H-
measure is between 0 and 1, with less than 0 being a collusive (joint monopoly) competition, less
than 1 being monopolistic competition and 1 being perfect competition. It can be shown, if the
bank faces a demand with constant elasticity and a Cobb-Douglas technology, that the magnitude
of H can be interpreted as an inverse measure of the degree of monopoly power, or alternatively,
as a measure of the degree of competition.
The second study, Bikker and Spierdijk (2007), also uses the PR-methodology, but allows the
degree of competition to vary over time and covers 101 countries. Table 1 documents by
individual country the measures of the two studies. The H-statistic of Claessens and Laeven
varies generally between 0.60 and 0.80, suggesting that monopolistic competition sometimes
approaching full competition is the best description of the degree of competition. The Bikker and
Spierdijk data show even larger variation in the degree of competitiveness across the larger
sample of countries, possibly due to their estimation technique allowing for time variation.
While there does not appear to be any strong pattern among types of countries, it is interesting
that some of the largest countries (in terms of number of banks and general size of their
economy) have relatively low values for the H-statistics. In both studies, Japan and the US, for
example, have H-statistics less than 0.5. This may in part be due to the more fragmented banking
markets in these countries, where small banks operate in local markets that are less competitive.
Since studies find differences between types of banks, especially in countries with a large
number of banks, such as the US, studying all banks may lead to a distorted measure of the
4
Specifically, the model to estimate the H-statistics for banking is:
it
it it it
it it it it
D
Y Y Y
W W W P
? ?
? ? ?
? ? ? ?
+ +
+ + + +
+ + + + =
) ln( ) ln( ) ln(
) ln( ) ln( ) ln( ) ln(
, 3 3 , 2 2 , 1 1
, 3 3 , 2 2 , 1 1
where
it
P is the ratio of gross interest revenue to total assets (proxy for output price of loans),
it
W
, 1
is the ratio of
interest expenses to total deposits and money market funding (proxy for input price of deposits),
it
W
, 2
is the ratio of
personnel expense to total assets (proxy for input price of labor),
it
W
, 3
is the ratio of other operating and
administrative expense to total assets (proxy for input price of equipment/fixed capital). The subscript i denotes bank
i, and the subscript t denotes year t.
11
overall competitiveness of a banking system.
5
However, even if one computes H-statistics using
data on large banks, rather than all banks for countries with many banks, results remain similar.
Other papers that use this methodology mostly also reject both perfect collusion as well as
perfect competition, i.e., they find mostly evidence of monopolistic competition (e.g., Wong,
Wong, Fong and Choi, 2006 for Hong Kong; Gutiérrez de Rozas, 2007 for Spain; Hempell, 2002
for Germany; Bikker and Haaf, 2001 summarize the results of some ten studies; Berger, 2000,
further reviews). Tests for emerging markets are rarer, but those done (e.g., Nakane, 2001, for
Brazil; Prasad and Ghosh 2005, for India; Yildirim and Philippatos 2007 for a sample of Latin
America countries) also find evidence of monopolistic competition. There remain large
variations across countries, however, and the ability to capture the degree of competition is still
imperfect, as estimates vary considerably among studies for the same banking systems (Bikker,
Spierdijk, and Finnie, 2006, review a number of studies). This is also clear from Table 1 since
there can be large differences between the two measures reported for individual countries (the
correlation is only 0.38, and the rank correlation only 0.29), showing some of the difficulty in
measuring competitiveness.
C. Empirical Approaches to Explain Competition
Fewer studies have tried to explain the degree of competition in particular markets. Claessens
and Laeven (2004) relate competitiveness (the H-measure) to indicators of countries’ banking
system structures and regulatory regimes. Importantly, and consistent with some other studies,
they find no evidence that their competitiveness measure negatively relates to banking system
concentration or the number of banks in the market. They do find systems with greater foreign
bank entry, and fewer entry and activity restrictions to be more competitive. Their findings
suggest that measures of market structures do not necessarily translate into effective competition,
consistent with the theory that contestability rather than market structure determines effective
competition. Others have studied the impact of financial liberalization on the degree of
competitiveness and find generally that liberalized systems are more competitive, in the sense of
having a higher H-measure.
There are some identification issues here, of course. Just like in studies finding that trade
openness raises efficiency in sectors open to foreign competition, it could be that more efficient
banking sectors are more likely to allow (external) competition, so that efficiency is the cause,
rather than just an effect, of contestability. And there can be omitted variables, as when financial
deregulation is adopted along with other efficiency-enhancing measures. Also, there can be
political economy arguments creating reverse causality or omitted factors—for example, when
insiders prefer closed, but inefficient financial systems. It means that studies assessing the impact
of openness on financial system and aggregate economic performance may have a hard time
identifying the direction of causality and disentangling the effects of financial reforms from
5
For example, De Bandt and Davis (2000) find monopoly behavior for small banks in France and Germany, and
monopolistic competition for small banks in Italy and large banks in all three countries. This suggests that in these
countries, small banks have more market power, perhaps as they cater more to local markets.
12
those of other measures. These caveats apply to most of the financial liberalization and reform
analyses, including those referred to here.
Other Empirical Regularities
There is a broad literature that has documented many empirical regularities between financial
system performance and structural factors within and across countries. This literature has related
actual financial markets behavior to factors deemed to be related to competition, including not
only structure, but also entry barriers, including on foreign ownership, and the severity of
activity restrictions, since those can limit intra-industry competition. Especially for banking
systems, a number of empirical studies have found that the ownership of the entrants and
incumbents, and the size and the degree of financial conglomeration (that is, the mixture of
banking and other forms of financial services, such as insurance and investment banking) matter
in a number of ways.
Many of these studies, however, do not use a structural, contestability approach to measure the
actual degree of competitive conduct and as such can not indicate whether the underlying
behavior is based on competitive or say oligopolistic behavior. Furthermore, often the focus has
been on the banking system only, neglecting other forms of financial intermediation that have
become more important directly in financial intermediation (capital markets, non-bank financial
institutions, insurance companies) or that play a role in determining banking system
competitiveness. Nevertheless, this literature suggests that the degree of competition has
consequences for financial sector performance and sheds some light on competition issues. It can
be classified in individual country and regional studies, cross-country studies, and studies on the
specific effects of internationalization.
Country and Regional Studies
Evidence of competition to matter is most convincingly available from liberalization steps, i.e.,
when reform “unambiguously” introduced more competition. This has notably been the case in
the US with the abolishment of restrictions on intra- and inter-state banking. Strahan (2003), a
major contributor himself, reviews this large literature and notes how it has been able to
document large real effects of US branching deregulation.
6
Besides documenting cross-sectional
regularities, many studies have investigated the effects of changes in structure and especially
consolidation in financial systems. (For an early review, see Berger, Demsetz and Strahan,
1999). Similar experiences have been documented for the EU following the Single Banking
Directives and other measures aimed at creating a more integrated and competitive financial
markets (see for example, CEPR 2005, for a review). And for most emerging markets similar
effects have been documented (see BIS, 2006, for a collection of country experiences).
6
He summaries it as follows: “This paper focuses on how one dimension of this broad-based deregulation—the
removal of limits on bank entry and expansion—affected economic performance. In a nutshell, the results suggest
that this regulatory change was followed by better performance of the real economy. State economies grew faster
and had higher rates of new business formation after this deregulation. At the same time, macroeconomic stability
improved. By opening up markets and allowing the banking system to integrate across the nation, deregulation made
local economies less sensitive to the fortunes of their local banks.”
13
These experiences have also highlighted the symbiotic relationships between increased
competition and changes in regulation: as competition intensifies, regulators are forced to
evaluate remaining rules by markets participants, leading to more focused rules. Foreign banks
have especially been found to stimulate improvements in the quality of local regulation and
supervision (Levine, 1996). As such, foreign bank entry and other forms of international
financial liberalization need not necessarily wait until the local institutional environment is fully
developed. And greater competition can highlight deficiencies that raise the costs of financial
intermediation or hinder access to financial services, and as such be an impetus to reform.
There have thus been large and rapid competitive gains in developed countries due to intra-
country and regional deregulation, and much progress in developing countries’ financial systems
that opened up and experienced large entry, especially in Central and Eastern Europe and Latin
America. Experiences have also shown, however, that gains will be hard to maintain in the
future, largely as it involved the easy steps of liberalization and opening up. The tasks now are to
deepen the competitive impact of liberalization. In most countries, major gains have come first
and foremost to the wholesale capital and corporate finance markets. And even this has been
with some limits since the competitive effects, even after eliminating barriers can remain limited
to some wholesale markets, regions or segments. Even without (many) formal barriers,
competition in many other markets remains imperfect and the gains from competition can be
limited to certain financial services (segments).
Extending the gains to other types of consumers of financial services has not proven easy. Even
in the most developed countries, with good financial institutions and solid institutional
infrastructures, the degree of effective competition in consumer and retail services still lags that
in other financial services segments. In the EMU, for example, following the Euro introduction,
retail deposit and mortgage interest rates have converged—beyond what was due to the
elimination of exchange rate risk, but other financial services still show large price and cost
differences (CEPR, 2005). Indeed in the EU, there remain very large differences in the cost of a
typical basket of retail banking services. The World Retail Banking Report (2005), for example,
estimate that for 19 countries in Europe, North America, Eastern Europe, and the Far East the
cost of a basket varied from €34 to €252, a 1-to-7.4 range, with the high and the low being two
EMU-countries. And beyond the traditional loan and deposit services, many wholesale products
still show large price differences, possibly due to imperfect competition.
7
Similar analysis for developing countries (Beck et al. 2008) shows even larger differences,
especially when scaled by income level. They show, for example, that over 700 dollars are
required to open a bank account in Cameroon, an amount higher than the GDP per capita of that
country. And they highlight that the annual costs to maintain an account in developing countries
can amount to as much as 7% of GDP per capita. While not due to lack of competition alone,
they do find that barriers are higher in countries where there are more stringent restrictions on
7
Even within fully integrated whole-sale markets (no currency risks, limited legal and regulatory differences, good
information, etc.), such as the U.S. and increasingly the EU/EMU, there still is, for example, a familiarity bias, e.g.,
more investment and entry closer to the home of the investor.
14
bank activities and entry, when banking systems are predominantly government-owned, whereas
more foreign bank participation is associated with lower barriers.
Many countries have given improving competition in these segments therefore a greater priority
(e.g., the Financial Sector Action Plan 2005-2010 of the European Commission launched in
2005; the UK following the 2001 Cruickshank report). This has shown that to further facilitate
competition it is not just a matter of opening up or liberalizing more, but rather that many
(subtle) barriers still need to be removed. The Cruickshank report in the UK showed that the
barriers to lowering costs for consumers and SMEs are often subtle, involving combinations of
high costs of switching bank accounts, hidden fees, and limited transparency. The 2007 EU
extensive competition inquiry in retail banking found a number of competition concerns in the
markets for payment cards, payment systems and retail banking products, with barriers not easy
to eliminate. The recent poor experience with sub-prime lending in the US, although mostly an
issue of lack of consumer protection and failure to conduct proper regulation and supervision,
has brought to the fore as well how unfettered competition does not prevent misuse and poor
outcomes.
Experiences have also brought some risks to light. Increased competition can have adverse
effects on access to financial services, as it can undermine the incentives of banks to invest in
information acquisition and thereby lower their lending to information-intensive borrowers.
More generally, more formal lending arrangements often associated with consolidation,
increased distance between lenders and borrowers, greater foreign bank entry, greater use of
technology and more competition—as has happened in many markets—may in theory have
adverse impact on access for some classes of borrowers. There is indeed evidence for the US, EU
and some emerging markets that consolidation has led to a greater distance and thereby to less
lending to more opaque SMEs (Berger, Miller, Petersen, Rajan and Stein, 2005; Carow, Kane
and Marayaman 2004, Karceski, Ongena and Smith 2005, Sapienza 2002, Degryse, Masschelein
and Mitchell, 2005; Boot and Schmeits, 2005 review this literature).
Evidence of this happening on a large scale in developed countries has been limited though and
there have been clearly offsetting trends as well.
8
But for developing countries and emerging
markets especially, these risks may be higher. Due to institutional weaknesses, including poor
information and institutional infrastructure and weak contracting environment, and more general
higher degrees of inequality, the access of SMEs and households in developing countries is often
already less than desirable. In these markets, the possibility exists of bifurcated markets: large
(international) banks may concentrate on large corporations, serving them using domestic and
international platforms with a wide variety of products; and on consumers, providing them with
financial services based on advanced scoring techniques and the like. The left out, middle
segment under such a scenario could be the SMEs. As competition intensifies, profitability may
go down and banks may have little incentives to invest in longer-term, relationships-based
8
In part due to technology, banks are better able today to combine soft and hard information in efficient manners,
and some banks have become very profitable specializing in SME-lending. Also, larger multiple-service banks can
have a comparative advantage in offering a wide range of products and services on a large scale, through the use of
new technologies, business models, and risk management systems, making them effective in the SME markets.
15
lending and information collection necessary for lending to this segment (for a model along these
lines, see Sengupta, 2007).
Improving access and promoting financial inclusion can therefore require some specific
measures, not just complementary to those increasing competition, but partly to offset possible
negative effects of competition. Whether improvements in the information institutional
infrastructure and the contracting environment can compensate fast enough, such that SMEs and
the like (still) have sufficient access to financial services, is an open question. Empirical
evidence on this has been limited to date, but early evidence is positive (see de la Torre, Soledad
Martínez Pería, and Schmukler, 2008).
Cross-country Studies
A number of recent papers have investigated across countries the effects on financial sector
performance of (changes in) financial regulations and specific structural or other factors relating
to how competitive the environment is. Factors analyzed include entry and exit barriers, activity
restrictions, limits on information sharing, and other barriers. Here the empirical findings are
fairly clear. In terms of development and efficiency, deregulation leading to increased
competition has led to lower costs of capital for borrowers and higher rates of return for lenders,
i.e., lower margins and lower costs of financial intermediation, spurring growth. Barth, Caprio
and Levine (2001) document for 107 countries various regulations in place in 1999 on
commercial banks, including various entry and exit restrictions and practices. Using this data,
Barth, Caprio and Levine (2003) show, among others, that tighter entry requirements are
negatively linked with bank efficiency, leading to higher interest rate margins and overhead
expenditures. These results are consistent with both tighter entry restrictions limiting competition
and the contestability of a market determining bank efficiency.
Using bank-level data for 77 countries, Demirgüç-Kunt, Laeven, and Levine (2004) find that
bank concentration, which as noted needs not proxy for the degree of competition, has a negative
effect on banking system efficiency, except in rich countries with well-developed financial
systems and more economic freedoms. Furthermore, limiting entry of new banks and implicit
and explicit restrictions on bank activities are associated with higher bank margins. The fact that
too much competition can undermine stability and lead to financial crises has been often argued
(see Allen and Gale, 2004 for a review), however, has been difficult to document systematically
(for example, Beck, Dermirguc-Kunt and Levine, 2002).
9
Finally, since overall growth combines
a number of aspects—efficiency, access and stability—the relationship between competition in
the financial sector and growth can be insightful. Claessens and Laeven (2005) relate their
competition measure to industrial growth in 16 banking systems. They find that greater
competition in countries’ banking systems allows financially dependent industries to grow faster,
thus providing comprehensive evidence that more competition in the financial sector serves the
broader economy well.
9
Boyd, De Nicolo and Jalal (2006) find for the US no trade-off between bank competition and stability, and that
bank competition fosters the willingness of banks to lend. See also ?ihák, Schaeck, and Wolfe (2006) and ?ihák and
Schaeck (2007).
16
Internationalization
There is also much evidence on the competitive effects of international openness and capital
account liberalization, particularly relevant for developing countries. Overall, the competitive
effects of cross-border capital flows have been found to be generally favorable. In terms of
development and efficiency, competition through cross-border capital flows has been shown to
lead to lower cost of capital for borrowers and higher (risk-adjusted) rates of return for lenders.
Evidence has shown that opening up internationally can spur growth, including through
improved financial intermediation (Bekaert, Harvey and Lundblad, 2005, and Henry 2006 review
this literature; Claessens 2006 reviews the competitive effects of cross-border banking).
Greater cross-border capital flows have been found, though, to increase access more for selected
groups of borrowers, e.g., large corporations that already had preferential access, especially in
developing countries. Tressel and Verdier (2007) find that in countries with weaker overall
governance, politically connected firms benefit relatively more from international financial
integration than other firms do. The growth benefits are consequently not always there. Kose et
al. (2008) highlight the need for a minimum set of initial conditions—good macro-economic
policies, financial and institutional development—for countries to benefit from financial
globalization. And while the effects on stability have generally been found to be favorable?as
international financial integration allows for greater international specialization and
diversification, international capital flows can add to risks, among others, through contagion and
greater risk of financial crises (IMF, 2007).
Foreign bank entry can be an alternative to cross-border capital flows to reach a market. The
entry of foreign banks has been found to have generally favorable competitive effects on the
development and efficiency of domestic, host banking systems (Chopra, 2007 provides an
extensive review of the literature). These generally positive results have occurred through
various channels, resulting from both direct financial intermediation and from competitive
pressures being put on existing banks. There is little evidence of increased volatility associated
with foreign bank entry; rather risks seem to be diversified better. Barth, Caprio and Levine
(2003) show, for example, that allowing foreign bank participation tends to reduce bank fragility.
The qualitative aspects of competitive foreign bank entry—new and better products—have by
nature been harder to document, but have possibly been most important.
The effects of entry of foreign banks have been found, though, to depend on some conditions,
and in some cases there can be negative consequences. Detragiache, Poonam, and Tressel,
(forthcoming) find that foreign bank entry in poor countries is associated with lower (growth in)
private credit. Beck and Soledad Martinez Peria (2007) find contrasting patterns for different
classes of borrowers for Mexico (see also Schulz, 2006 which reviews foreign bank entry in
Mexico). More generally, while evidence of immiserizing effects of internationalization is
limited, achieving the full gains from entry often requires some (minimal) convergence of
regulations, legal and other institutional infrastructure. Furthermore, interactions between capital
account liberalization, financial services liberalization and domestic deregulation can affect the
gains.
Complexity is, however, increasingly due to the changing nature of financial services provision.
Financial services industries are continuously changing, not just due to the removal of barriers
and increased role of non-bank financial institutions, but also due to increased globalization and
17
technological progress, which are all affecting the degree and type of competition. Even in
market segments where competition has been intense and benefits in terms in access and costs
have been very favorable, such as wholesale and capital markets, new competition policy
challenges has arisen, nationally and internationally. The consolidation of financial services
industries, the emergence of large, global players, the large investments in information
technology and brand names necessary to operate effectively and to gain scale, and the presence
of large sunk costs make it difficult to assure full competition, even abstracting from the special
characteristics of financial services. The increased importance of networks is also affecting the
nature and degree of competition. As such, the positive experiences documented here may not
prevail unless policies adjust as well.
D. Tools to Analyze
The literature reviewed makes clear that the tools used by policy makers for identifying and
addressing competition issues in the financial sector need to be specific. It is also clear that tools
will need to be adjusted in light of changes in financial services industries. Measures typically
used to date for measuring lack of competition (e.g., Herfindahl or concentration indexes of
banks or branches within a geographic area) are clearly quite limited, even a few decades ago
and are now even more so given changes in financial services industries. For example, rigid rules
and guidelines, e.g., certain cutoffs for Herfindahl or concentration indexes, will not suffice.
Rather, it is necessary to rely on solid analyses of degree of competitive behavior. Yet, this ends
up being especially complicated since the more sophisticated analytical and empirical tools
developed for measuring competition in other industries are hard to apply to financial services
industries. The unclear production function for financial services, the tendency to produce and
sell bundles of services, the weaker and more volatile data, the presence of network properties,
etc. make assessing the degree of competitive behavior complex. A few examples illustrate the
difficulties.
To measure effectively using the tools from the traditional industrial organization literature (such
as pass-through coefficients) (changes in) competition in banking, the most traditional financial
service for which much data is available, is already complex. Data are often limited and span few
observations. Most tests require at least 50 bank-year observations. Since in many developing
countries the number of banks with good financial information is low, one cannot conduct year-
by-year estimates of the degree of competition, or only subject to large confidence intervals,
making comparisons over time hard. Using data from a larger sample of countries, e.g., all Latin
American countries or EU-15, creates other difficulties, such as comparability.
Networks are another complication that can give rise to special competition measurement issues.
Financial services provision involves the use of an ever greater number of networks, such as
payments, distribution and information systems. This means barriers to entry can arise due to a
lack of access for some financial services providers to essential services. In banking, for
example, network barriers can be closely related to which financial institutions have access to the
payments system, typically banks only. ATM and other distribution networks can further be
limited to banks, or only be available at higher costs to non-bank financial institutions. Obvious
network effects arise when some banks have large nation–wide coverage in branches or ATMs,
as it can allow them to service costumers more cheaply.
18
A recent development in developing countries especially is banking through networks of agents,
where say retail chains with large network of stores serve as correspondent agents for banks
(examples include Bolivia, Brazil, Colombia, India, Mexico, Pakistan, Peru, and South Africa:
see further Mas and Siedek, 2008). This links competition in the retail sector with that in the
financial sector. Also, two-sided networks effects exist in payment cards markets, since larger
point-of-sale (POS) networks are more valuable to both cardholders and merchants. This leads to
complex measurement issues, for which the credit card industries provide an interesting example
(see Pindyck 2007).
Another example of a network is that access to credit and other information on borrowers and
other clients is often limited to (a subset of) incumbent banks. In addition, network
externalities?especially in capital markets, e.g., the agglomeration effects of liquidity?can
complicate the application of competition policy. Ownership and governance structures can play
a role as well. In many stock exchanges, derivatives and other formal trading markets,
ownership and governance structures are changing from mutual to for profit ownership and with
fewer owners. This can make traditional means of ensuring competition work poorly, or at least,
differently,
10
and new competition approaches can be required. There are also forces towards
vertical integration, especially in capital markets (e.g., the integration of trading systems with
clearing and settlement), while other forces push towards more separation in other aspects (e.g.,
clarity in functions) or horizontal consolidation (e.g., economies of scale). Each of these raises
(new) forms of possible anti-competitive behavior.
An example of the complexity in defining a market is payments services. In payments services,
as in many other financial services these days, the issue arises what constitutes the relevant
product market. Payment cards include credit cards, debit cards and charge (or stored value)
cards. While different in terms of underlying technology, pricing schemes and some auxiliary
services, these cards are similar in their cash substitute function, in which case competition
analysis should cover all type of cards. Alternatively, however, payment cards can be seen as
part of a bundle of different services like ATM cash withdrawal, payment service at point-of-sale
(POS) terminals, etc. In which case, payment cards should be analyzed as part of the competition
in bundles of household financial services, including deposit services. This issue is relevant not
just in developed countries, but also in developing countries where cards are rapidly becoming
substitute to traditional banking services. For example, in some markets cards with pre-paid
balances have been introduced that can be used for (small) payments without the need for a bank
account. These and others forms of branchless banking (e.g., mobile banking using phones, see
Ivatury and Mas, 2008) introduce new competition issues.
An example from the capital markets is the increasing trend toward internalization of trading
within financial institutions, institutional investors and other financial intermediaries. While this
can save transactions costs for the final consumer, it makes for less overall transparency and can
lead to anti-competitive outcomes. Yet, data are more difficult to obtain and analysis to establish
anti-competitive behavior is more complex.
10
For example, a private provider of an essential service will have different incentives to serve all in need than a
mutual owned provider where all uses are also members/owners
19
In addition to these complications, market and product definitions have become (more) difficult.
It is somewhat trite, but nevertheless very important from a competition policy point of view to
state that many financial markets today are global in nature, making any application of
competition policy to national markets only of lesser value than in the past. In addition, the
definition of a specific financial service (and its market) has become more difficult. Today, for
example, there are fewer differences than in the past between the markets for pension services
and for asset management services; after all, many people can save in both ways and, provided
tax rules are largely harmonized between the two, will do so. And with many non-financial
institutions providing (near) banking and other financial services, the boundary between banks
and non-bank financial institutions has become more blurred.
E. Current Status
The upshot of these complications and changes in financial services industries is that, for a same
degree of liberalization, competition may be less assured today than in the past. The increasing
presence of high fixed costs and large sunk costs in the production of whole-sale financial
services, can mean significant first mover and scale advantages, possibly leading to natural
monopoly and market power. Externalities, say in e-finance in the adoption of payments using
mobile phones, can make the adoption of new technologies exhibit critical mass properties. In
consumer finance, switching costs may have increased?for example, because automatic
payments are increasingly linked to one’s specific bank account number. This means in turn that
customers can not and do not easily change provider, leading to more complex competition.
There is indeed some evidence from studies on banking systems that the progress in increasing
competition may have slowed down from the early 2000s on, with even some indications of a
decline in competition in some markets (Bikker and Spierdijk, 2007). The robustness of this
finding is yet to be confirmed, and the exact causes are unclear, and in any case, are likely to be
multiple.
The difficulty to document (changes in) competition with current tools shows that the tools to
measure the (lack of) competition policy in financial services` industries need to be enhanced or
even be newly designed to address new issues and changes. This will often require developing
and applying new, economically fully justified models, which will take time and can be complex.
Short of doing so, however, much can be done. Much information on the competitive structure
can still be discerned by focusing on price setting for specific products or financial functions,
e.g., what are the fees charged for consumer retail products or for processing individual pension
premiums or payments. In addition, more focus can be given to the pricing and availability of
inputs necessary to produce financial services, e.g., do all types of financial institutions have
access on the same basis to the retail payments system? This type of information can also be
better disclosed such that users can act on it.
III. IMPLICATION FOR COMPETITION POLICY IN THE FINANCIAL SECTOR
There was already little analysis of the design and conduct of competition policy in the financial
sector. And the “special nature” of finance, with its emphasis on stability, always meant that
competition policy was considered more complicated in the financial services industry. Changes
in financial services industries create their own set of new competition issues and there are surely
20
no easy answers to how reflect these in policy. As such it is hard to be definitive on how
competition policy should be conducted in the financial sector. What is clear that the two aspects
that have to be considered fresh in competition policy include the approaches and the
institutional arrangements.
A. Approaches
One can think of three possible, and largely complementary approaches to conducting
competition policy. One is assuring that entry/exit rules allow for contestable markets in terms of
financial institutions and products. Two is leveling the playing field across financial services
providers and financial products such that there is effective intra-sectoral competition. And three
is assuring that the institutional environment (payments system, credit bureaus, etc) is
contestable. The first has been the traditional approach and the norm. As analyzed above, it has
been quite effective, and will have to remain the essential cornerstone of competition policy in
the financial sector, as in other sectors. But, as noted, on its own it may have reached its limits.
The second, leveling the playing field, means harmonization (or convergence), both among
financial services providers (banks, insurance companies, pension funds, asset management,
etc.), markets—national, regional and global—and between different, but functionally equivalent
types of products?whether called banking, insurance, or capital markets products.
Harmonization’s goal should be that, within particular markets, products are not regulated
differently depending on what type of financial institution provides the service. And products
that offer the same functionality of service, but may be “labeled” differently, i.e., fall under
different regulatory approaches, need to be treated similarly. Harmonization (or convergence)
includes addressing differences in taxes, capital adequacy requirements, transparency/disclosure,
etc. across sectors and products. This will be useful not just to increase competition, but also to
avoid regulatory arbitrage and to reduce differences in the net overall regulatory burden of
products. The increased creation of complex financial products that straddle various markets and
institutions makes the need for a common regulatory approach all the more necessary.
Harmonization across financial service sectors and products is a long-standing issue. On one
hand, the big barriers across financial service sectors have been removed: only in some countries,
but increasingly less so, are there still (large) regulatory barriers between commercial banks,
investment banks, insurance companies and other financial institutions. The fact that these large
barriers have been removed, however, does not make the issue of harmonization moot since
often many smaller barriers remain. Some differences will be due to some “path dependence;”
for example, some products emerged as insurance products but migrated to becoming savings
products. Others arise from the existence of subtle barriers, e.g., some products may be linked to
the payments system for which access is limited. And others again exist because of linkages with
other economic policies, e.g., tax preferences may be linked to pension products but not to
savings. Furthermore, many financial products come bundled (e.g., a checking account has both
savings, payments and often as well credit?overdraft?functions linked to it), making it hard to
compare regulatory burdens of individual products with each other (e.g., the costs of complying
with Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) may be
assigned to a checking account or may be spread over various products).
21
In all cases, there is a need to go more in depth. Yet, designing an ex-ante approach to perfectly
level the playing field is conceptually and in practice very difficult. The current approach, which
is largely reactive—as producers and consumers are faced with differences, they may approach
the various regulators and appeal for harmonization—has therefore benefits. It has also risks,
however. There can be a race to the bottom as the lowest treatment becomes the norm for all
products. It also opens up the possibility of lobbying for favorable treatments. This can go
counter to the valid reasons for differences in regulatory treatments based on, say, prudential
concerns or consumer protection. A proactive approach by authorities and competition agencies
can therefore still be useful.
This can be complemented by given consumers more information. Better price information and
more disclosure on the costs of various financial services can help consumers identify
uncompetitive products and/or start formal complaints. Many countries have centralized places
where, say, interest rates on deposit and standard loan contracts can be found. Experiences show
though that this remains of limited effectiveness when done alone. Market solutions can greatly
and often more effectively foster competition than government initiatives alone, witness the
many firms offering price comparators. Regardless, and similar to what is needed for assessing
the degree of competition, agencies could require better data on prices and costs at the level of
individual products and make this data available. This would be a very important starting point
for users of financial services that often lack empirical bases.
The third approach, assuring that the institutional environment is contestable, is complex as well.
This would mean that the various inputs required for the production and distribution of financial
services, including network services (for example, payments and check system, credit bureaus,
other networks, etc), need to be available to all interested in using them, be fairly and uniformly
priced, and be efficiently provided. For no part of a specific financial service production and
distribution chain should there be any undue barriers or unfair pricing. These steps are
considered basic requirements in most other network industries, where (private) firms are
producing and delivering services (e.g., phone, other telecommunications, energy, and water),
using common networks (e.g., telecommunication lines, power lines, railroads, pipelines, etc.).
With the often subtle barriers in financial services industries, however, these steps and policy
recommendations to foster more effective competition are not easy. In many markets, policy
actions and recommendations have largely been in the form of putting more pressures on the
financial industry, including by relying on codes of conduct, to reduce extensive barriers,
converge standards, limit collusive practices, and encourage consumer mobility by lowering
switching costs. Some strong general policy intervention can at times be necessary, however, to
force more rapid adjustments, create standardization or remove barriers. Some example illustrate
the benefits of strong actions.
Over the past decade many governments have required various retail payments systems initially
developed by (groups of) individual banks within a nation to be integrated and available to all
consumers. This greatly increased not only the quality of payments services, but also often
lowered costs. The EU recently required charges for financial transfers among Euro-zone
countries to be equal to those for domestic transfers (subject to some conditions), which
illustrates the benefits of strong actions. Another option is mandating easy portability of one’s
22
bank account number, which is being introduced in some EU countries. Mandating by
government rule a level playing field can be equally necessary in capital markets to assure fair
trading and pricing for small as well as large investors. In many markets, traders are required to
always use the best price.
11
Important to assuring a contestable institutional infrastructure in finance will be the formulation
and application of standards, but here policy makers will face trade-offs. As the payments system
examples show, in networks, compatibility of systems is mostly based on standards. Standards
can also help avoid coordination problems in firms’ technology choice, and can help consumers
forecast whether the specific technology will be widespread, leading to reduced uncertainty and
less risk of consumer lock-in, and thereby avoid non-adoption (waiting). In several cases after
the industry agreed on a common standard, the adoption of the good or service indeed increased
sharply. In financial services, one good example has been the Society for Worldwide Interbank
Financial Telecommunication (SWIFT) protocol for transacting international payments
introduced in 1977. At the same time, with standards, users can be forced to make a choice.
Furthermore, joining more than one network is often ruled out by contract. Exclusivity
arrangements can lead to the predominance of a large network, even when more differentiated
networks with more consumer choice could proliferate. Anti-competitive behavior can then
easily follow. Policy makers face then a trade-offs between on one hand encouraging market
development by supporting (a particular) standard(s) and achieving critical mass with the best
technology, versus at the same time stimulating competition and not favoring incumbents.
In these and other areas, competition policy approaches in the financial sector can perhaps learn
from those used in other network industries, many of which have adopted relatively sophisticated
competition policies. For example, in many infrastructure industries, the ownership and/or
management of the network has been separated in recent years from the provision of services to
assure fairer competition. Access policies and pricing of network services are often subject to
government regulatory review. In these other industries, some rules for operating on the network
may be standardized through direct government actions or through self-regulatory agencies
assigned with this task, and not left to the (private sector) operators or owners (alone).
Some of these other network industries have also come to grip with the issue of assuring access
to basic services for a wide class of consumers. Through mechanisms such “universal service
obligations,” uniform price rules for essential inputs in producing services or key outputs,
selected subsidies and other (tax) incentives, policy makers have been able to assure (near)
universal access in these other network industries, at least in the most developed countries.
These models are also being applied in developing countries. These approaches may equally
apply to those financial services with large network properties. For example, in payment
services, standard uniform pricing rules could imposed, similar to uniform rates for certain basic
postal, phone, telecommunications, water or electricity services.
11
In the US, this is embodied in the SEC “order protection rule”: no matter where a customer order is routed, it
should receive the best price that is immediately and automatically available anywhere in the national market
system. This principle promotes competition among individual market centers by ensuring that dominant markets
cannot ignore smaller markets displaying the best price.
23
B. Institutional Arrangements
The institutional arrangements for competition policy often will need to change as well. For one,
competition policy need to be separated more clearly from prudential oversight. Some countries
have already taken competition policy out of the central bank or supervisory authority, but in
many countries the responsibility for competition policy still lies with the prudential authority.
This creates conflict of interests (for a review of the arguments, see Carletti and Hartmann,
2002). Separation does not mean that the prudential authority would have no say in competition:
the prudential authority could have some (veto) rights in any specific decisions or general policy
changes. Furthermore, the competition authority could still rely on analyses by the prudential
authority, say, in case technical expertise is scarce in the competition authority. But clearer
separation does address the conflict of interests' issue that has hindered effective competition
policy in the financial sector.
Second, there is much more need to coordinate better, and preferably bring together, competition
policy functions now often dispersed among various agencies within a country (e.g., separate for
banking and non-bank financial institutions, or with prudential regulators, or among both
specialized and general competition policy agencies). Reducing this dispersion will avoid the
inconsistent application of competition policy across financial institutions and products that are
functionally equivalent. It will also allow for the buildup of skills necessary for proper
competition policy analysis. Of course, in many countries, there is also need to improve the skill
base in the judicial system where competition cases may be finally settled or arbitrated.
It will also be important to consider the interactions between competition policy and consumer
protection policies specific to the financial sector.
This concerns three sets of issues: assuring markets work better for all final consumers—what is
sometimes called assuring a proper business conduct; protecting individual consumers—which
can be considered a narrow version of consumer protection; and assuring consumers obtain the
greatest benefits from financial services provision, for example, through proper information and
education—which makes for an even wider concept of consumer protection. Competition policy
is relevant for all these issues, as both too little and too much competition can hurt consumers
through each of these channels.
The costs and benefits of single versus multiple supervisory agencies have been debated for
some time
12
and no simple answers exist here on the best balance, from the point of view of
financial stability or from the perspective of efficiency of financial services provision. It does
relate, however, to the issues of competition and harmonization across financial services and
financial services providers. Financial sector competition policy design thus has to consider the
organization of the supervisory agencies. The move towards single supervisory authorities across
the world—countries as diverse as Estonia, Kazakhstan, South Korea, Nicaragua, and the UK
12
The issue of consolidated supervision is less debated.
24
have adopted it in the last decade—presumably could help with reducing unnecessary differences
arising from multiple regulatory regimes.
13
Superficially, differences in the degree of de-jure or de-facto harmonization (or lack thereof)
among financial instruments are not obvious between various supervisory regimes. Even where
there is a single supervisory authority, it has not done away with all (or even many) of the
regulatory harmonization issues across sectors or products. Presumably, competitive pressures
from producers and users and the lobbying strength of these constituencies relative to regulators
will be the most important factors driving the (de-facto) reduction in barriers. In that respect, a
more fragmented structure of regulation and supervision may well lead to more de-facto
harmonization and convergence as financial services industries are stronger positioned to argue
for regulatory changes and agencies “compete” with each other.
14
Nevertheless, whether any of
these institutional arrangements are superior from the point of view of efficient financial services
provision has not been researched in depth and may remain unclear in any case given the
difficulty of attribution. And the organization of a supervisory authority in a single country may
be of little relevance when competition for some financial services already is on a global basis.
The changing nature of financial services provision also means that other aspects affect the
competitive environment. For example, the competitive structure in telecommunication markets
may affect the market for electronic (or remote) finance, as in case of mobile payments. And,
obviously, there is a much greater need today for international cooperation among various
national agencies in the application of competition policy. Harmonization and convergence
across markets, already a very complex undertaking within countries, will be compounded
regionally or globally. The EU-experience, which has been engaged for quite some time now in a
process of financial integration and convergence, shows the tenacity needed to create a single
market for financial services. It shows that requiring some uniformity in minimal regulations is
not sufficient since inconsistencies with national rules and laws still arise, as other policy areas
need to be adjusted, which take much time and effort.
These national, regional and global experiences also show how many conceptually difficult
questions can arise with convergence. For example, while many banks operate across borders
without barriers, liquidity support and lender of last resort facilities are still organized nationally.
13
Although there is this trend, it is not general. Some countries have recently adopted the model of integrating
systemic stability and all?banking, insurance and pension?individual financial institutions prudential oversight, in
one agency, but separate from the agency for market conduct supervision. Others have left systemic stability with
the central bank, but organized prudential and market conduct under two separate agencies. Yet others have made
no changes and still have separate prudential banking, securities markets and insurance supervisors operating in one
country (and sometimes multiple of each, e.g., the US).
14
Obviously, this is highly context and country dependent, and ignores many other dimensions. For example, with
strong financial institutions and weak regulators, a greater influence of private interests could lead in some countries
to lax and low-cost standards, with perhaps greater competitiveness, but with more risk of financial instability. In
other environments, capture of the regulator may lead to rent-seeking by (selected) financial institutions, but with
limited risks.
25
This creates inconsistencies with policies for dealing with financial insolvency.
15
While this topic
largely concerns financial stability and is beyond this paper (there is large literature here; see the
papers collected in Caprio, Evanoff and Kaufman, 2006), these differences can also have
competitive implications. For example, banks from some countries may have more generous
access to the local safety net than banks from other countries do. Of course, these issues also
arise within countries, as when state-owned banks attract deposits at low interest rate because
they are (perceived to be) covered more generously by the safety net, as has happened often in
developing countries. And they arise both ex-ante and ex-post, as when weak banks receive
liquidity and/or solvency support.
16
These and other issues mean that competition agencies will
have to be both reactive and proactive in their investigations. Today, agencies often only respond
to events such as large scale mergers and acquisitions, but undertake little analysis of
competitive conditions in existing markets. An approach targeted at key areas of concern of
possible anti-competitive behavior would be useful.
Lastly, harmonization and convergence depend these days to a great extent on international
standards, of which the ones developed by the BCBS, IOSCO, IAIS and CPSS are the most
visible. This has become a large body of “soft law”.
17
The ambition levels of these standards
vary, from suggestions to achieve a minimum common denominator among existing national
requirements, which is most often the case, to going beyond existing national requirements.
Although the standards are voluntary in nature and implementation is left to countries
themselves, some of the standards can be quite intrusive. In most cases, functional convergence
and arbitrage would make remaining cross-border regulatory differences of little consequence in
hindering competition. Some major initiatives, however, like Basel II and other rules affecting
(cross-border) banking may end up hindering effective competition in some respects.
18
15
Although liquidity management may be done centrally by the foreign bank in its home country, branches of
foreign banks are typically eligible to receive liquidity support from the local host central bank. In case of
insolvency of the head bank, however, the home country authorities are responsible, which can involve home
government resources in case the whole bank fails. In single currency regions, like the EMU, there is an additional
need for coordination between member countries’ liquidity support and ECB’s monetary policy.
16
This has happened in many financial crises (see Claessens, Klingebiel and Laeven (2003) for a overview of
measures used in restructuring), but in the past has not led to competitive questions. The recent cases of the
liquidity support for Northern Rock in the UK, the solvency support for IKB in Germany and the “bail-out” of Bear
Stearns, however, have attracted some attention for their potential ant-competitive implications. Also, the (on-
going) large scale liquidity support during the recent financial crisis from the US Federal Reserve Board, the ECB
and the Bank of England could raise such questions.
17
There are issues of the legitimacy and governance of the standards setting bodies, which are not discussed here.
18
The Basel II rules, for example, encourage international banks to use the same risk management approaches
across national jurisdictions, which creates a level playing field and can help with competition. At the same time,
too uniform application could lead credit risks to be priced too rich in some countries (e.g., emerging markets) and
too thin in other countries. Adapting the approaches to capture the risks in various markets appropriately is
necessary, but would negate some of the gains of uniformity.
26
IV. CONCLUSION
I review the state of knowledge on competition in the financial sector and how competition
policy is and should be organized. I show that competition matters as in other industries, but that
there are some specific analytical issues. Notably is the effect of excessive competition on
financial stability, but also that the degree of competition matters for the access of firms and
households to financial services. As a consequence, the view that competition in financial
services is unambiguously good is more naive than in other industries. And it is not sufficient to
analyze competitiveness from a narrow concept alone or focus on one effect only. One has to
consider a broader set of objectives, including efficiency, access to services to various segments
of users, and systemic financial sector stability, and possible tradeoffs among these objective. In
terms of the factors driving competition in the financial sector and empirical measurement of
competition, I highlight that one needs to consider standard industrial organization factors, such
as entry and exit and contestability, but also that financial services provision has many network
properties in production, distribution, and consumption, making for complex competition
structures.
Besides the theoretical complexity, empirical evidence on competition in the financial sector is
scarce and often not (yet) clear. Much of the current literature relates performance indicators to
countries’ financial system structures and regulatory regimes without formal measures of
competitiveness. And the contestability view of competition is not the one typically applied.
Rather, the market structure-conduct-performance paradigm is at best used. What is available,
however, suggests that competition has spurred improvements, including greater product
differentiation, lower cost of financial intermediation, more access to services, and enhanced
stability. This evidence is fairly universal, from developed countries to many developing
countries. In terms of factors driving competition, to date, it has been achieved by traditional
means, i.e., making systems more open and contestable, i.e., having low barriers to entry and
exit, with in developing countries internationalization of financial services often driving changes.
As globalization, technological improvements and de-regulation further progress, the gains of
competition can be expected to become even more wide-spread across and within countries.
At the same time, the review shows that once the easier steps have been taken, policies to
achieve effective competition in all dimensions, and balancing the trade-offs between
competition and other concerns, become more challenging. As financial services industries
evolve, and as financial markets and products become more complex and global, new regulatory
and competition policy issues arise. This means that approaches to competition issues need to
adjust, important since competition policy in the financial sector is often already behind. But the
theoretical and empirical literature is just catching up with the special issues and changes in
financial services industries.
To move forward, therefore, besides improving the measurement of competition, much can be
learned from policies already standard in many other industries, especially network industries. I
make some suggestions on what approaches, as well as institutional arrangements and tools best
fit a modern view of competition policy in the financial sector. I also suggest that policy makers
can greatly enhance available data so that users will have the information needed to assess the
costs of different financial services. Finally, with rapid changing financial services industries,
there is a need to remain agile and adjust competition policies and procedures.
27
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Table 1. PR-Measures (H-statistics) of Competitiveness of Banking Systems Around the World
Bikker and Spierdijk Claessens and Laeven
country H (at end of the period) H average
Algeria 0.34
Andorra 0.88
Argentina 0.55 0.73
Armenia 0.43
Australia 0.29 0.8
Austria -0.05 0.66
Azerbaijan 0
Bahamas 0.6
Bahrain 0.41
Bangladesh 0.87 0.69
Belgium 0.73 0.73
Bermuda 0.87
Bolivia 0.99
Botswana 0.23
Brazil 0.55 0.83
Canada 0.2 0.67
Cayman Islands 0.96
Chile 0.93 0.66
China PR 1.57
Colombia 0.78 0.66
Costa Rica 0.78 0.92
Croatia 0.04 0.56
Cyprus -0.09
Czech Republic 0.82 0.73
Denmark 0.27 0.5
Dominican Republic 0.23 0.72
Ecuador 0.67 0.68
El Salvador 0.45
Estonia 0.11
Finland -0.07
France 0.82 0.69
Germany 0.8 0.58
Ghana 0.61
Greece 0.47 0.76
Hong Kong -0.04 0.7
Honduras 0.81
Hungary 0.79 0.75
Iceland 0.55
India 0.49 0.53
Indonesia -0.06 0.62
Ireland 1.12
Israel 0.15
Italy 0.08 0.6
Ivory Coast -0.04
Japan 0.44 0.47
Jordan 0.33
Kazakhstan 0.28
Kenya 0.62 0.58
Korea 1.03
Kuwait 0.36
Latvia 0.52 0.66
35
Bikker and Spierdijk Claessens and Laeven
country H (at end of the period) H average
Lithuania 0.4
Luxembourg 0.37 0.82
Macau 0.23
Macedonia -0.01
Malaysia 0.7 0.68
Malta 0.3
Mauritius 0.58
Mexico 0.37 0.78
Moldova 0.58
Monaco 0.41
Morocco 0.32
Mozambique 0.61
Nepal 0.9
Netherlands 0.92 0.86
New Zealand -0.25
Nigeria 0.74 0.67
Norway 0.5 0.57
Oman 0.35
Pakistan 0.54 0.48
Panama 0.56 0.74
Paraguay 0.75 0.6
Peru 1.37 0.72
Philippines 0.28 0.66
Poland 0.03 0.77
Portugal -0.02 0.67
Romania 0.59
Russian Federation 0.41 0.54
Saudi Arabia 0.51
Senegal 0.18
Singapore 0.51
Slovakia 0.16
Slovenia 0.29
South Africa 2.03 0.85
Spain 0.52 0.53
Sri Lanka 0.67
Sweden -0.08
Switzerland 0.74 0.67
Taiwan 0.94
Thailand 0.63
Trinidad Tobago 0.21
Turkey 0.43 0.46
Ukraine 0.44 0.68
United Arab Emirates 0.46
United Kingdom 0.76 0.74
United States 0.46 0.41
Uruguay 0.53
Venezuela 0.74 0.74
Vietnam 0.74
Zambia 0.53
NOTES: The table displays two measures. The Bikker and Spierdijk measure allows for variation over time and the reported H-
statistic for each country is the one estimated for the end of the sample period. The samples used vary considerable across
countries. The Claessens and Laeven measure is the estimated average H-statistic for each country in their sample calculated for
the years 1994-2001 using the Panzar-Rosse (1987) approach. In their case, the H-statistics are based on a sample that includes
observations from countries with a total number of at least 50 bank-year observations and observations on at least 20 banks.
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