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Assessing nature of competition in banking sector of Pakistan
Accepted Manuscript Assessing Nature of Competition in Banking Sector of Pakistan Muhammad Tahir, Assistant Professor, Syed Sadaqat Ali Shah, MS Scholar, Muhammad Asim Afridi, Assistant Professor PII:
S2405-9188(16)30048-4
DOI:
10.1016/j.jfds.2017.04.001
Reference:
JFDS 20
To appear in:
The Journal of Finance and Data Science
Received Date: 2 December 2016 Revised Date:
6 March 2017
Accepted Date: 10 April 2017
Please cite this article as: Tahir M, Shah SSA, Afridi MA, Assessing Nature of Competition in Banking Sector of Pakistan, The Journal of Finance and Data Science (2017), doi: 10.1016/j.jfds.2017.04.001. This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.
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Assessing Nature of Competition in Banking Sector of Pakistan
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1. Muhammad Tahir, Assistant Professor, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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2. Syed Sadaqat Ali Shah MS Scholar, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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(Corresponding Author)
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3. Muhammad Asim Afridi Assistant Professor, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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Assessing Nature of Competition in Banking Sector of Pakistan
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Abstract This study examines the nature of competition in banking sector of Pakistan and assesses whether the banking sector is in long-run equilibrium or not. The study uses annual panel data for a sample of 30 banks, over the period 2007-2015 by employing Rosse-Panzar (1977) methodology. The findings show that banking sector of Pakistan is operating under
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characteristics of monopolistic competition. The findings further show that the equilibrium hypothesis is rejected for the banking sector over the period of analysis. The current study is
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expected to benefit policymakers, banking sector itself and the country’s central bank. The findings confirm that massive deregulations and financial liberalization has contributed positively and has improved competitive condition of the banking sector that is expected to improve further in the future.
Key words: Competition, Banking Sector, Pakistan, Deregulation, Panel data, Rosse-Panzar
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model.
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1. Introduction The banking sector of Pakistan is in a continuous state of evolution since deregulation initiatives launched in late 1990s. The amendments in banking act 1974 transferred shares of five big state
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owned banks to private sector. The amendments had two impacts on banking sector. First, shares of state owned banks were transferred to private banks and secondly it led to establishment of new banks in the country, consequently transforming the banking industry from a more concentrated to less concentrated banking sector. The opening of new banks, however, created
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problems which led to mergers and acquisitions. For instance small banks were unable to compete with large banks and further the small banks were unable to maintain minimum capital
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adequacy requirement imposed by the central bank.
This study studies the nature of competition in banking sector after major developments in terms of establishment of domestic banks and permitting foreign banks to operate in the country at the same cost function as established firms. The subsequent mergers and acquisitions1 among banks call for to study what was nature of competition and to investigate whether the banking market was in long-run equilibrium or not. This study therefore, first, assesses nature of competition in
equilibrium or not.
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country’s banking sector and secondly investigates whether the banking market was in long-run
The studies of Mahmood (2009) and Mirza et al. (2016) have investigated banking sector of Pakistan in terms of concentration and market power exercised by banks respectively. The
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previous studies have multiple flaws when measuring degree of competition in the banking market. For example the study of Mahmood (2009) excluded the impact of minimum capital
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requirement (MCR), minimum capital adequacy ratio (CAR) and minimum deposit rates on competition in the banking industry because the requirement by the central bank changed dynamics of competition in the banking sector2. Similarly their studies fall short in considering overall banking market. In other words the studies neglected to consider overall banking sector instead of taking selected banks (for instance our study takes into account all banks operating across the country- Islamic banks, specialized banks, public and private banks and foreign banks 1 For example M&A of HSBC with and into MeezanBank in 2014 and M&A of Barclay Bank with and into Habib Bank Limited in 2015 (Source: Competition Commission of Pakistan) 2 The imposition of minimum capital requirement (MCR) and minimum capital adequacy ratio (CAR) by SBP in 2008 forced smaller banks to merge with larger banks thereby changing the environment of competition.
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respectively). In addition the econometric model employed by Mirza et al. (2016) has ignored to include macroeconomic variable although the macroeconomic (annual GDP growth) variable also impact banking sector in an economy and that GDP and competition in banking industry are interrelated. Further as Mirza et al. (2016) has researched banking sector from 2004 to 2012 it
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means his study has not taken into account Islamic banks in their study.
This study overcomes all these discrepancies by, first, considering overall banking sector, regardless of their specialist practices. Second the current paper, unlike previous study (Mirza et
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al. (2016) which has used quarterly data to measure competitive level, consider annual reports instead of quarterly or half year reports published by the banks to measure nature of competition. Thirdly, due to imposition of MCR and CAR by the State Bank Pakistan, country’s banking
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sector regulator, the study intends to investigate whether or not the banking sector is in long run equilibrium, and finally the study considers a time series macroeconomic variable (annual GDP growth) to see its impact on banking competition.
The rest of the paper is patterned as follow. Section 2 of the paper presents historical background and developments in the banking sector of Pakistan. Section 3 briefly reviews relevant literature.
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Section 4 details theory, methodology and data sources. Section 5 explains empirical results and discussion. Section 6 concludes and gives future directions. 2. Developments in banking sector of Pakistan
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Prior to initiation of reforms in banking sector of Pakistan in the end of 1990the banking industry of the country was dominated by five big banks3.Amendments were made in 1991 in Banking Act of Pakistan 1974 to align banking sector of the country with international standard, improve
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efficiency, competitiveness of the sector to its advantage and to attract private sector investment. The amendments in the act resulted in a more liberalized banking industry. The deregulations of state owned banks resulted in large private sector investment in the sector which attracted new competitors through licenses issued to them by State Bank of Pakistan. This move of issuing licenses to new entrants consequently increased shares of the private sector, subsequently lowering overall concentration of the banking market.
3
National Bank of Pakistan, Allied Bank of Pakistan Limited, Habib Bank Limited, Muslim Commercial Bank, United Bank Limited
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The privatization opened the economy for new domestic and foreign entrants, increased the scope and importance of information technology, pushed banks to adopt efficient ways to grab market shares and exercise their market power. The excessive use of information technology and employment of skilled human resource now differentiate banks from their market competitors.
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The banking sector has displayed remarkable and notable performance not only in monetary terms but has promoted a culture of professionalism, innovation, efficiency and inclusion of unbanked population in the financial system through offering branchless banking. The competition has since then intensified and the customers are now feeling comfortable with
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services of banks.
The banking sector, however, experienced shrinkage and a tilt toward concentration when the
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newly established small banks were unable and incapable to compete with large banks4 which ultimately led to mergers and acquisitions in the sector. The mergers and acquisitions forced State Bank of Pakistan in 1995 to impose moratorium on issuing commercial banking licenses to new banks. One reason of subsequent mergers and acquisitions in the banking sector was requirement of minimum capital requirement laid by State Bank of Pakistan (SBP).Second reason for mergers and acquisition in the banking sector was establishment of Islamic banks
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because the new mode of banking attracted massive deposits in the years after its establishment. Therefore to prevent banks from liquidity problems and subsequent expected bankruptcies the SBP as per prudential regulations required banks to raise their minimum capital adequacy requirement from Rs 5 billion in 2008 to Rs 23 billion by the year 2013. Developments in
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banking sector recently and establishment of Islamic banks therefore call for to study overall
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banking sector instead of selected banks. The country’s banking sector although has been recognized for its rapid growth, efficiency, promotion of professionalism and low cost products and services, the sector has been on the other hand engulfed by dilemma of high interest spread5, one reason behind higher profitability of banks.
4
According to ESH hypothesis large banks, in terms of profitability, performs well as compared to small banks for reasons they are more efficient than small banks. 5 SBP has now laid minimum rate on PLS accounts with effects from June 1, 2008. Source: [email protected]
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Although the banking sector during decades of its operations after deregulation has shown remarkable performance it has not been researched whether the market has been competitive and contestable, that is no research to date has been done to assess nature of competition in banking sector of the country and to test whether the sector is in long run equilibrium. This paper is
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expected to benefit banking sector itself, the central bank and policy makers in the future. This paper in addition will help policy makers whether to bring changes in regulatory environment so as to ensure competition in banking sector, subsequently to achieve financial stability.
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3. Literature Review
Various approaches have been employed to measure and quantify competitiveness of banking
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sector (Rosse-Panzar, 1977; Lau 1982, Bresnahan, 1982 and Panzar and Rosse, 1987; Boone, 2008).These methodologies, specifically Rosse-Panzar (1977) and Panzar-Rosse (1982), have also been extend to industries other than banking (see Ashenfelter and Sullivan, 1987; Fischer and Kamerschen, 2003; Li and Marinc, 2016), however with criticism on the H-statistic (see Shaffer 1982a, 1982b; Hyde and Perloff, 1995; Shaffer and Spierdijk, 2015). A number of studies conducted in different countries by employing different methodologies
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indicate banking markets operate under monopolistic competition (see for example, Nathan and Neave, 1989; Molyneux et al., 1994;Hondroyiannis et al., 1999;Belaisch, 2003; Claessens and Laeven, 2004; Al- Muharami et al, 2006; Mathews et al, 2007; Al-Muharami, 2009). The study of Bikker and Haaf (2002) finds that banks in EU are characterized by monopolistic competition
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and that the competition in local markets is weaker6 and stronger in international markets. Testing for an impact of consolidation on competition in banking sector of Korea revealed that
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the sector has not been impacted (Park, 2009). De Bandt and Davis (2000) on the other hand find that in Germany the banks operated under monopolistic competition and in case of France the small banks exercised monopoly. The investigation of Arab Middle Eastern banking sector (Murjan and Ruza, 2002) and the banking industry of eight countries in Latin America and Europe (Gelos and Roldos, 2002) by employing P-R methodology indicate the banking industry operate under monopolistic competition.
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Caminal and Matutes (2002) argue that when banking sector is not competitive credit rationing shrinks, loans are larger subsequently enhancing chance of banking sector failures.
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The results of Lerner (Beck et al., 2013) and Lerner and Boone (Clerides et al., 2014) indicate declining banking competition during 2000s for many world economies, however the market power has increased in the post financial crisis years. However on employing Bresnahan- Lau model Nakane (2001) concluded that Brazilian banking sector operate under competitive
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condition that is expected to remain in long run. Simultaneously Maudos and Nagore (2005) employ Lerner Index and find a U-shaped relationship between size of the banks and the market power. They indicate a positive link between concentration and market power and that efficient banks exercise market power. In case of Argentina Burdisso et al. (2001) report presence of
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almost perfect competition for the period 1997-1999. Williams (2012) investigated Latin American banking sector for estimation of market power and indicates that competitive condition
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fell over the period 1985 to 1990 although the market operated under monopolistic competition. Although competition in banking sector is beneficial in terms of efficiency, it however induces financial instability (Allen and Gale, 2004). This argument is supported by study of Boyd and De Nikolo (2005) that financial stability is affected by stronger market power exercised by banks which subsequently leads to bankruptcy. The research of Berg and Kim (1998) studied the impact of multi-product operations on competition in banking sector. They examine banks’
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behavior in a segment where retail as well as corporate banks operate simultaneously. Asymmetries in level of competition were revealed by the study which in each segment can be compared to consumers’ characteristics. Similarly Abel and Roux (2016) investigated Zimbabwean banking sector by employing widely used Panzar-Rosse H-statistic to measure
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competition in the country’s banking sector for the period 2009-2010. The findings of the study indicate the banking sector of Zimbabwe operated under characteristic of monopolistic
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competition with H-statistic ranging between 0.46 and 0.56. In other words the H-statistic is neither negative, indicating monopoly situation, nor greater than a unit, indicating existence of perfect competition.
In contrast to measuring competition in the banking sector the study of Barbosa et al (2015) investigated Brazilian banking sector by taking into account multi-product banking operations. The study, in other words, investigated whether or not multi-products offered by banks have impact on market power. The findings show that banks exercise market power if and when they offer classic banking products (loans and credit cards) as well as other banking products
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(brokerage services, insurance as well as capitalization bonds) in contrast to banks that offer only classic banking products. On investigating banking sector of Morocco, by considering five banks holding about 80 percent
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of market’s credit shares, the finding of Fatine et al. (2015) show that the banking sector is not competitive by price/quantity and is characterized by monopolistic competition. Similarly the findings, by employing Panzar-Rosse model, indicates that between 1993 and 2010 the banking sector claim stabilization in competitive level, varying from 0.37 to 0.28, however, indicating
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decline in degree of competition.
Exploring banking sector of Fiji for competition by employing Panzar-Rosse H-statistic the
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findings of Kumar and Patel (2014) indicate that the banking sector of Fiji operate under characteristic of monopolistic competition and that the competition in the banking sector is biased toward monopoly or short-run oligopoly. The H-statistic of 0.254 and 0.180 indicate that the banking sector of Fiji is characterized by lower level of competition. Furthermore the findings show that revenues of the banks are positively impacted by interest expenses, CAR, number of branches and negatively impacted by personnel expenses, firm size, and other
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operating expenses.
On investigating banking sector of India Datta (2005) shows that due to trend of globalization the banking sector competition in the country has improved and the competition in the sector is expected to improve further in the future. Employing Bresnahan-Lau model the results indicate
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the competition in banking sector of India is less than monopoly and more than Cournot oligopoly. Another study by Vesala (1995) by examining competitiveness in Finnish banks over
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a period of eight years, 1985-1992, concluded that higher level of contestability existed for the sampled period. To find evidence of existence of competitiveness in banking sector Spiller and Favaro (1984) researched Uruguayan banking sector and suggested that the response of banks vary to actions of other banks in the same banking sector. The literature review shows that the research on competition in banking market around the globe is abundant; however any research relevant to banking market in Pakistan is rare. The research of Mahmood (2009) and Mirza et al. (2016) respectively as measuring competition in country’s banking sector is not sufficient to justify that the banking sector is competitive. For example the
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study of Mirza et al. (2016) have measured degree of competition in banking sector of Pakistan by explaining quantitatively level of competition in the banking market. Similarly the study used quarterly dataset for assessing degree of competition in the banking sector. This study on the other hand measures nature of competition in the banking sector of Pakistan instead of measuring
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degree of competition in the banking sector. This study is different because in measuring nature of competition in the banking sector requires to test, firstly, whether or not the banking sector is in long-run equilibrium which is not covered in the previous papers. Simultaneously this study overcomes existing discrepancies by employing Rosse-Panzar H-statistic (1977) instead of
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Panzar-Rosse (1982) H-statistics to quantify competitive condition of the banking sector and to test whether or not the banking sector is in long-run equilibrium. Secondly the study employs
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annual dataset to quantify nature of competition in the banking sector of the country. Simultaneously the imposition of MCR and CAR by country’s central banks has enforced banks to merge with larger financially stronger banks to retain banking sector stability and to prevent depositors’ money. The focus on overall banking sector of the country is interesting. Firstly, because the market structure after de-regulations, mergers and acquisitions and establishment of Islamic banks have apparently brought tremendous changes in banking sector, It is therefore of
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utmost significance to assess nature of competition in the banking sector. Secondly, since regulatory measures too have changed since de-regulation it is important to test how competition has varied after de-regulation. Thirdly, any change in Prudential Regulations (PR hereafter) and regulatory measurements have direct and natural impact on banking sector, therefore the study
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calls for investigation of the competitive condition of the banking sector and to examine whether the market is in long-run equilibrium or not.
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This paper therefore aims to extend existing literature to banking sector of Pakistan by first assessing nature of competition in the banking sector and secondly to investigate whether the sector is in long run equilibrium by using annual panel data of 30 sampled banks for the period 2007-2015 by employing Rosse-Panzar H-statistic methodology.
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4. Theory, model specification and data 4.1 Theory Structure Conduct Performance (SCP hereafter) model (Mathew et al, 2007) dominated early studies to identify structure of the market. The assumptions of these studies were that the market
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structure is exogenous that is any change in structure impact conduct of the firm and subsequently the performance of the firm. In these studies profitability was regressed on concentration ratio in these studies and the results, subsequently, suggested a positive relationship between profitability and concentration ratios. The results showed that market power
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is exercised by banks in concentrated markets. Efficient Structure Hypothesis (ESH)on the other hand suggests otherwise; in terms of profitability large banks tend to perform very well as
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compared to small banks because of their efficiency (Mathew et al, 2007). Both SCP and ESH however do not end debate because both of them have deficiencies. For example they both focus only on profitability instead of deviation of output price from marginal cost- it is most suitable theoretical basis for measuring competitive condition (Paul, 1999).
New Empirical Industrial Organization (NEIO) overcomes these discrepancies (Mathew et al, 2007). Two most commonly used approaches in this strand of literature are Rosse-Panzar (1977)
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reduced-form revenue framework and Bresnahan- Lau (1982) respectively. The robustness of RP is higher in small samples whilst an anticompetitive bias is shown by Bresnahan-Lau model in small sample (Shaffer, 2004).
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4.2 Model specification
This study uses Rosse-Panzar methodology to assess nature of competition in banking sector of
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Pakistan. Log linear revenue, as dependent variable, is employed to assess competitive condition in banking sector while log return on assets is used to find out whether the banking market is in long run equilibrium or not.
Multiple non-structural measures (Rosse-Panzar, 1977; Panzar-Rosse, 1982, 1987; Lerner Index, 1934; Boone Indicator, 2008) have been employed to assess competitive conditions in the banking sectors. Simultaneously when it is unfeasible to employ structural measures to quantify
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competitive conditions7, the reduced form revenue approaches are employed to measure and quantify competitive conditions in the form of differentiating conduct of the firm and the market power. Albeit less powerful than structural measures the data requirement in reduced-form revenue models are less stringent and thus minimizes the risk of employing model characterized
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by misspecification (Fischer and Kamerschen, 2003). The non-structural measure known as Rosse-Panzar H-statistic does not necessitate the availability of required data on output and input levels (Martin, 2001), it however takes into account firm-specific rental cost of capital services.
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The empirical estimation is performed in two steps. In the first step the study assesses nature of competition in banking sector of Pakistan and in the second step the study estimates whether banking market is in equilibrium or not. For estimating competitive condition the following
ln
+
ln
+
ln
is total revenue of the bank i in year t,
+
ln
+
(1)
is vector of input price (PL, Price of labor;
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Where
=
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reduced form revenue equation is employed:
PK, Price of capital; PF. Price of fund),
is a vector of bank-specific variable (RISKASS,
ratios of provisions to total assets; ASSETS, total assets; BR, number of branches of each bank to the total number of all banks),
is a stochastic disturbance term. The vectors i and t
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impact overall banking market and
is a of macroeconomic variable (annual GDP growth) that
denotes bank and time in years respectively. Reduced form revenue equation is employed to
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calculate R-P H-statistic. In equation (1), The Rosse-Panzare H-statistic (1977) is calculated from reduced form revenue equation. H is the sum of elasticities of total revenue with respect to each of the bank’s input prices (that is PL, PK, PF).
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The structural measures become unusable due to unavailability of required data for quantifying competitive conditions or when the model adequacy or competency in measuring the competitive conditions becomes questionable.
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The conditions for market to be monopolistic, monopoly or perfect is given in table 1. For testing H-statistic it is important to first test whether the banking market is in long-run equilibrium or not. Therefore to test the market for equilibrium we replace ln
in eq. (1) with
= ′ +
′ ln
+
′ ln
+
′ ln
+
(2)
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ln
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pre-tax profit to total assets. The equation to test for equilibrium is as follow:
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For equilibrium,
=
′ =0
The theory of competitive condition and equilibrium condition (Mathew et al., 2007) is
[Insert Table 1 here]. 4.3 Data Sources
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explained in table 1.
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Yearly annual reports has been collected from individual bank’s website and from the website of country’s central bank, State Bank of Pakistan, spanning over nine years from 2007 to 2015. The study has considered overall banking sector, including commercial banks, Islamic banks,
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specialized banks, and foreign banks. Due to unavailability of required data the study takes into account a sample 30 banks. The data for time series macroeconomic variable annual GDP growth has been obtained from World Development Indicators (WDI), World Bank. The study uses panel data with fixed effects. Fixed effect model is considered more appropriate than random effect model as evidenced by the results of Hausman (1978). To deal with heterogeneity panel data is an effective and appropriate way because; the data is more informative, there is higher variability, collinearity is low or no collinearity is present, the degree of freedom and the efficiency is higher respectively. Hausman test is conducted to whether run
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fixed or random effects. Due to rejection of H0 or in other words acceptance of H1 and significance at 5 percent it is justified to use fixed effects. The results are shown in Table 2.
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[Insert Table 2 here]
5. Results and Discussions 5.1 Equilibrium in banking sector
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For estimating competitive condition in the banking market it is required to test whether the market is in long run equilibrium or not. Because the banking sector over recent years has
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witnessed major changes through mergers and acquisitions non-existence of equilibrium over period of analysis is not a surprise. The results are presented in Table 3: [Insert Table 3 here].
The result of E= -0.10828 indicates that equilibrium hypothesis is rejected for the banking sector over the period of analysis. The equilibrium test was performed to see any impact of explanatory
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variables on ROA. The coefficients of PL (unit cost of labor), PK (unit cost of capital) and PF (unit cost of fund) as -0.019, 0.004 and-0.093 respectively shows that input prices PL and PF negatively impact ROA in the long run. The high cost of labor impacts banks in terms of lowering their returns in long run. Similarly banks that have high cost funds in terms on interest
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payment can cost banks in terms of returns. The positive impact of PK on ROA indicate that if efficient capital is employed then even if cost of capital is higher the banks still can enjoy
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positive returns on assets in the long run. In other words banks that spend more on capital (in other words banks spending more on intellectual capital in the form of periodic training and development of employees) enjoy positive returns on assets. The results show that PL, PK, RISKASS and BR are statistically significant at one percent significance level, PF and ASSETS are significant at 5 percent level whilst GDP is significant at ten percent significance level. The estimated equation has good explanatory power because the explanatory variables show 81.5 percent variation in dependent variable.
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The negative impact of RISKASS on ROA shows that provisions against non-performing loans in the long run affect banking return on assets negatively. This poses two threats to the banks in the long run. Firstly, higher the provisions against non-performing loans the lower the money available for banks in the future to lend to investors. Secondly additional cost is incurred by
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banks when loans are waived off or when borrower defaults on loans. Furthermore the positive relation of ASSET shows that the more the assets banks have higher will be return on assets. However keeping unnecessary branches can have negative impact on banks’ ROA. Although the results show an opposite relationship between GDP and ROA the impact however is negligible.
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The relationship between GDP growth and ROA suggest they both are related to each other as
5.2 Competition in banking sector
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any change in equilibrium will have change in growth of GDP and vice and versa.
By obtaining estimates of equilibrium model we can without any hindrances calculate H-statistic for competitive condition. Our finding of H-statistic of 0.728 is closer to the finding of Mahmood (2009) whose findings are in range of 0.8 to 0.9 but far from finding of Mirza et al. (2016) whose results suggest H-statistic of 0.998. The results of competitive condition are
[Insert Table 4 here].
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presented in table 3.
The results indicate that except PF, RISKASS and GDP the ratios of PL, PK, ASSET and BR are
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statistically significant at one percent significance level. The coefficients of input prices show a positive impact on revenue of the banks. The value of H-statistic of 0.728 shows that banking sector of Pakistan operates under characteristic of monopolistic competition. Cost of labor
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increases when banks open new branches to meet the market demand and to maintain market shares. Opening up of new branches increases every sort of cost for the bank at a rate that revenue at all times exceeds expenses. The value of cost of capital is interesting because it is positively related to bank revenue. Due to induction of professional and qualified staff by banking industry the cost of capital too has risen for banks, however, the relationship is negligible and the impact is minimum. The negative value of ASSET indicates that it may cost 8
The wider deviation between the current study and study conducted by Mirza et al. (2016) could be due to inclusion of overall banking sector or could be due to employment of annual data, rather than quarterly data, for the analysis purpose.
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banks in terms of profitability if they hold unnecessary or excessive assets at hand, thereby impacting future investment and overall economy9. Simultaneously the negative RISKASS shows that revenue of the bank erodes when banks increase provisions against loans. The existence of opposite relationship between REV and GDP is interesting. Any change in
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competitive environment impact country’s GDP growth. The relationship here, however, is negligible. 6. Conclusion and future directions
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The study intended to assess competition in banking sector of Pakistan over the period 20072015 by employing yearly data obtained from websites of respective banks and country’s central
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bank. The study employed methodology of Rosse-Panzar for the sample banks to carryout analysis. The results are consistent with results of Mathew et al (2007) which show that British banking operated under monopolistic competition when Rosse-Panzar(1977) methodology is employed. The results show that banking sector of Pakistan is monopolistically competitive and that the banking market of the country is not in long-run equilibrium which means that major ins and outs are happening in the country’s banking market through mergers and acquisitions. The
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merging of banks and acquisitions by banks show that the dynamics of competition are changing in the banking market subsequently improving overall competition in the banking market. Although competition over years has improved considerably in the banking market it is important to strengthen the banking sector further by further improving regulatory environment
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by minimizing barriers to banks to enter the market. Banking sector of the country should be
•
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further investigated. For example:
A multi-product approach should be used to assess competitive condition because banks in the country over the recent past decade are offering more products to their customers than before which therefore calls for investigation in whether the banking sector is competitive or not.
•
The behavior of commercial banks (conventional versus Islamic bank) should be investigated to find nature of competition and to test whether the market is in long run
9
Banks that keep higher assets at hand are expected to impact banking sector and overall economic growth because when they hold higher unnecessary assets at hand they spent less on investment which subsequently costs overall economy.
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equilibrium for reason that the shares of Islamic banks in the banking sector since its inception has multiplied, so the competition should be quantitatively measured and assess which banking model is more competitive. This sort of investigation will show which mode of banking is prioritized by customers and depositors.
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Due to recent mergers and acquisition against backdrop of requirement of minimum paid up capital and minimum deposit rates by country’s central bank in the banking sector it should be tested whether the mergers and acquisitions in the banking industry has resulted in
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overall economic stability of the country.
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concentrated banking sector and to find its subsequent impacts on banking competition and
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•
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14. Burdisso, T., Catena, M. and D'Amato, L., 2001. Bank competition in Argentina: 19971999. In VI Jornadas de EconomíaMonetaria e Internacional (La Plata, 2001). 15. Caminal, R. and Matutes, C., 2002. Market power and banking failures.International Journal of Industrial Organization, 20(9), pp.1341-1361.
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16. Claessens, S. and Laeven, L., 2004. What drives bank competition? Some international evidence.Journal of Money, Credit, and Banking, 36(3), pp.563-583. 17. Clerides, S., Delis, M.D. and Kokas, S., 2015. A new data set on competition in national banking markets. Financial Markets, Institutions & Instruments, 24(2-3), pp.267-311.
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18. Datta, N., 2005. Competition in Indian commercial banking sector in the liberalized regime: An empirical evaluation. WB 741235.
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19. De Bandt, O. and Davis, E.P., 2000. Competition, contestability and market structure in European banking sectors on the eve of EMU. Journal of Banking & Finance, 24(6), pp.1045-1066. 20. Fatine, F.A., Zakaria, F. and Hakam, A., 2015. Evaluation of banking competition in Morocco: implementation of Panzar and Rosse model. International Journal of Economic Policy in Emerging Economies, 8(3), pp.245-261.
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21. Fischer, T. and Kamerschen, D.R., 2003. Measuring competition in the US airline industry using the Rosse-Panzar test and cross-sectional regression analyses. Journal of Applied Economics, 6(1), pp.73-93.
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22. Gelos, R.G. and Roldós, J., 2004. Consolidation and market structure in emerging market banking systems. Emerging Markets Review, 5(1), pp.39-59.
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23. Hausman, J.A., 1978. Specification tests in econometrics. Econometrica: Journal of the Econometric Society, pp.1251-1271. 24. Hondroyiannis, G., Lolos, S. and Papapetrou, E., 1999. Assessing competitive conditions in the Greek banking system.Journal of International Financial Markets, Institutions and Money, 9(4), pp.377-391. 25. Hyde, C.E. and Perloff, J.M., 1995. Can market power be estimated?. Review of Industrial Organization, 10(4), pp.465-485. 26. Kumar, R.R. and Patel, A., 2014. Exploring competitiveness in banking sector of a small island economy: a study of Fiji.Quality & Quantity, 48(6), pp.3169-3183.
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27. Lau, L.J., 1982. On identifying the degree of competitiveness from industry price and output data.Economics Letters, 10(1), pp.93-99. 28. Lerner, A., 1995. The concept of monopoly and the measurement of monopoly power. In Essential Readings in Economics (pp. 55-76). Macmillan Education UK.
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29. Li, S. and Marinč, M., 2016. Competition in the clearing and settlement industry. Journal of International Financial Markets, Institutions and Money, 40, pp.134-162. 30. Mahmood, 2009.An analysis of degree of competition in banking sector of Pakistan through as direct measure of Market contestability.SBP Research Bulletin, 5(2).
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31. Martin, S., 2001. Notes on the Rosse-Panzar Statistic. URL: http://www. krannert. purdue. edu/faculty/smartin/aie2/RPNotes1. pdf. 32. Matthews, K., Murinde, V. and Zhao, T., 2007. Competitive conditions among the major British banks. Journal of Banking & Finance, 31(7), pp.2025-2042. 33. Maudos, J. and Nagore, A., 2005. Explaining market power differences in banking: a cross-country study.InstitutoValenciano de InvestigacionesEconómicas.
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34. Mirza, F.M., Bergland, O. and Khatoon, I., 2016. Measuring the degree of competition in Pakistan’s banking industry: an empirical analysis. Applied Economics, pp.1-14. 35. Molyneux, P., Lloyd-Williams, D.M. and Thornton, J., 1994. Competitive conditions in European banking. Journal of banking & finance, 18(3), pp.445-459. 36. Murjan, W. and Ruza, C., 2002.The competitive nature of the Arab Middle Eastern banking markets.International Advances in Economic Research, 8(4), pp.267-274.
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37. Nakane, M.I., 2001. A test of competition in Brazilian banking.Banco Central doBrasil Working Paper, (12).
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38. Nathan, A. and Neave, E.H., 1989. Competition and contestability in Canada's financial system: empirical results. Canadian journal of Economics, pp.576-594. 39. Panzar, J.C. and Rosse, J.N., 1987. Testing for" monopoly" equilibrium.The journal of industrial economics, pp.443-456. 40. Park, K.H., 2009. Has bank consolidation in Korea lessened competition?.The Quarterly Review of Economics and Finance, 49(2), pp.651-667. 41. Paul, C.J.M., 1999. Cost Structure and the Measurement of Economic Performance: productivity, utilization, cost economics, and related performance indicators. Springer Science & Business Media.
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42. Rosse, J.N. and Panzar, J.C., 1977. Chamberlin vs. Robinson: an empirical test for monopoly rents. Bell Laboratories.
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43. Shaffer, S., 1982a, April. A non-structural test for competition in financial markets. In Proceedings of a conference on bank structure and competition, Federal Reserve Bank of Chicago (Vol. 225, p. 243). 44. Shaffer, S., 1982b. Competition, conduct and demand elasticity. Economics Letters, 10(12), pp.167-171.
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45. Shaffer, S. and Spierdijk, L., 2015. The Panzar–Rosse revenue test and market power in banking. Journal of Banking & Finance, 61, pp.340-347.
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46. Spiller, P.T. and Favaro, E., 1984. The effects of entry regulation on oligopolistic interaction: The Uruguayan banking sector. The Rand Journal of Economics, 15(2), pp.244-254. 47. Vesala, J., 1995. Testing for competition in banking: Behavioral evidence from Finland.
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48. Williams, J., 2012. Efficiency and market power in Latin American banking. Journal of Financial Stability, 8(4), pp.263-276.
ACCEPTED MANUSCRIPT 1 Table 1. Conditions for competitive banking market
Competitive Conditions H ≤ 1 indicates banking market has monopoly.
-
H = 1 indicates existence of perfect competition, natural monopoly or sales maximizing firms.
-
0 < H < 1 means market operates under characteristic of monopolistic competition.
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-
Equilibrium Conditions E = 0 shows that market is in long-run equilibrium.
-
E < 0 shows non-existence of equilibrium or market is in dis-equilibrium.
Table 2. Hausman Specification Test
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-
Competitive condition model Equilibrium condition model Chi-Sq stats
43.7530
Chi-Sq d.f
7
Prob
0.0000
38.4558 7
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0.0000
Hausman test is conducted to choose between fixed and random effects.
Coefficient
Standard error
t-stats
Prob.
-0.1179
0.0488
-2.4136
0.0166
Price of Labor Price of Capital
-0.0189 0.0041
0.0042 0.0014
-4.4453 2.9089
0.0000 0.0040
Price of Fund Ratios of provisions to total assets Total Assets
-0.0934 -1.0118 0.0087
0.0463 0.0345 0.0034
-2.0131 -29.2739 2.5652
0.0453 0.0000 0.0109
No. of Branches Annual GDP Growth
-0.0075 -0.0012
0.0028 0.0007
-2.6777 -1.7096
0.0079 0.0887
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Variables C
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Table 3. Estimates of equilibrium, dependent variable LNROA.
R2 = 0.8150 F-stats (Probability) = 28.5174 (0.0000) E = -0.10828
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Table 4. Estimates of competitive condition with dependent variable LNREV. Standard error
t-stats
Prob.
C
3.871
2.1859
1.771
0.078
Price of Labor
0.331
0.1003
3.305
0.001
Price of Capital
0.066
0.0240
2.735
0.007
Price of Fund
0.331
0.2840
1.166
Ratios of provisions to total assets
-0.821
1.8627
-0.441
Total Assets
-0.380
0.1474
-2.580
No. of Branches
0.370
0.1171
Annual GDP Growth
-0.024
0.0176
F-stats (Probability) = 9.2786 (0.0000)
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H= 0.728717
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0.245
0.660
0.010
3.163
0.002
-1.384
0.168
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R2 = 0.5890
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Coefficient
S2405-9188(16)30048-4
DOI:
10.1016/j.jfds.2017.04.001
Reference:
JFDS 20
To appear in:
The Journal of Finance and Data Science
Received Date: 2 December 2016 Revised Date:
6 March 2017
Accepted Date: 10 April 2017
Please cite this article as: Tahir M, Shah SSA, Afridi MA, Assessing Nature of Competition in Banking Sector of Pakistan, The Journal of Finance and Data Science (2017), doi: 10.1016/j.jfds.2017.04.001. This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.
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Assessing Nature of Competition in Banking Sector of Pakistan
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1. Muhammad Tahir, Assistant Professor, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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2. Syed Sadaqat Ali Shah MS Scholar, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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(Corresponding Author)
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3. Muhammad Asim Afridi Assistant Professor, Department of Management Sciences, COMSATS Insitute of Information Technology Abbottabad, Pakistan [email protected]
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Assessing Nature of Competition in Banking Sector of Pakistan
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Abstract This study examines the nature of competition in banking sector of Pakistan and assesses whether the banking sector is in long-run equilibrium or not. The study uses annual panel data for a sample of 30 banks, over the period 2007-2015 by employing Rosse-Panzar (1977) methodology. The findings show that banking sector of Pakistan is operating under
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characteristics of monopolistic competition. The findings further show that the equilibrium hypothesis is rejected for the banking sector over the period of analysis. The current study is
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expected to benefit policymakers, banking sector itself and the country’s central bank. The findings confirm that massive deregulations and financial liberalization has contributed positively and has improved competitive condition of the banking sector that is expected to improve further in the future.
Key words: Competition, Banking Sector, Pakistan, Deregulation, Panel data, Rosse-Panzar
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model.
1
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1. Introduction The banking sector of Pakistan is in a continuous state of evolution since deregulation initiatives launched in late 1990s. The amendments in banking act 1974 transferred shares of five big state
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owned banks to private sector. The amendments had two impacts on banking sector. First, shares of state owned banks were transferred to private banks and secondly it led to establishment of new banks in the country, consequently transforming the banking industry from a more concentrated to less concentrated banking sector. The opening of new banks, however, created
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problems which led to mergers and acquisitions. For instance small banks were unable to compete with large banks and further the small banks were unable to maintain minimum capital
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adequacy requirement imposed by the central bank.
This study studies the nature of competition in banking sector after major developments in terms of establishment of domestic banks and permitting foreign banks to operate in the country at the same cost function as established firms. The subsequent mergers and acquisitions1 among banks call for to study what was nature of competition and to investigate whether the banking market was in long-run equilibrium or not. This study therefore, first, assesses nature of competition in
equilibrium or not.
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country’s banking sector and secondly investigates whether the banking market was in long-run
The studies of Mahmood (2009) and Mirza et al. (2016) have investigated banking sector of Pakistan in terms of concentration and market power exercised by banks respectively. The
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previous studies have multiple flaws when measuring degree of competition in the banking market. For example the study of Mahmood (2009) excluded the impact of minimum capital
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requirement (MCR), minimum capital adequacy ratio (CAR) and minimum deposit rates on competition in the banking industry because the requirement by the central bank changed dynamics of competition in the banking sector2. Similarly their studies fall short in considering overall banking market. In other words the studies neglected to consider overall banking sector instead of taking selected banks (for instance our study takes into account all banks operating across the country- Islamic banks, specialized banks, public and private banks and foreign banks 1 For example M&A of HSBC with and into MeezanBank in 2014 and M&A of Barclay Bank with and into Habib Bank Limited in 2015 (Source: Competition Commission of Pakistan) 2 The imposition of minimum capital requirement (MCR) and minimum capital adequacy ratio (CAR) by SBP in 2008 forced smaller banks to merge with larger banks thereby changing the environment of competition.
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respectively). In addition the econometric model employed by Mirza et al. (2016) has ignored to include macroeconomic variable although the macroeconomic (annual GDP growth) variable also impact banking sector in an economy and that GDP and competition in banking industry are interrelated. Further as Mirza et al. (2016) has researched banking sector from 2004 to 2012 it
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means his study has not taken into account Islamic banks in their study.
This study overcomes all these discrepancies by, first, considering overall banking sector, regardless of their specialist practices. Second the current paper, unlike previous study (Mirza et
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al. (2016) which has used quarterly data to measure competitive level, consider annual reports instead of quarterly or half year reports published by the banks to measure nature of competition. Thirdly, due to imposition of MCR and CAR by the State Bank Pakistan, country’s banking
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sector regulator, the study intends to investigate whether or not the banking sector is in long run equilibrium, and finally the study considers a time series macroeconomic variable (annual GDP growth) to see its impact on banking competition.
The rest of the paper is patterned as follow. Section 2 of the paper presents historical background and developments in the banking sector of Pakistan. Section 3 briefly reviews relevant literature.
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Section 4 details theory, methodology and data sources. Section 5 explains empirical results and discussion. Section 6 concludes and gives future directions. 2. Developments in banking sector of Pakistan
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Prior to initiation of reforms in banking sector of Pakistan in the end of 1990the banking industry of the country was dominated by five big banks3.Amendments were made in 1991 in Banking Act of Pakistan 1974 to align banking sector of the country with international standard, improve
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efficiency, competitiveness of the sector to its advantage and to attract private sector investment. The amendments in the act resulted in a more liberalized banking industry. The deregulations of state owned banks resulted in large private sector investment in the sector which attracted new competitors through licenses issued to them by State Bank of Pakistan. This move of issuing licenses to new entrants consequently increased shares of the private sector, subsequently lowering overall concentration of the banking market.
3
National Bank of Pakistan, Allied Bank of Pakistan Limited, Habib Bank Limited, Muslim Commercial Bank, United Bank Limited
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The privatization opened the economy for new domestic and foreign entrants, increased the scope and importance of information technology, pushed banks to adopt efficient ways to grab market shares and exercise their market power. The excessive use of information technology and employment of skilled human resource now differentiate banks from their market competitors.
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The banking sector has displayed remarkable and notable performance not only in monetary terms but has promoted a culture of professionalism, innovation, efficiency and inclusion of unbanked population in the financial system through offering branchless banking. The competition has since then intensified and the customers are now feeling comfortable with
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services of banks.
The banking sector, however, experienced shrinkage and a tilt toward concentration when the
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newly established small banks were unable and incapable to compete with large banks4 which ultimately led to mergers and acquisitions in the sector. The mergers and acquisitions forced State Bank of Pakistan in 1995 to impose moratorium on issuing commercial banking licenses to new banks. One reason of subsequent mergers and acquisitions in the banking sector was requirement of minimum capital requirement laid by State Bank of Pakistan (SBP).Second reason for mergers and acquisition in the banking sector was establishment of Islamic banks
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because the new mode of banking attracted massive deposits in the years after its establishment. Therefore to prevent banks from liquidity problems and subsequent expected bankruptcies the SBP as per prudential regulations required banks to raise their minimum capital adequacy requirement from Rs 5 billion in 2008 to Rs 23 billion by the year 2013. Developments in
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banking sector recently and establishment of Islamic banks therefore call for to study overall
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banking sector instead of selected banks. The country’s banking sector although has been recognized for its rapid growth, efficiency, promotion of professionalism and low cost products and services, the sector has been on the other hand engulfed by dilemma of high interest spread5, one reason behind higher profitability of banks.
4
According to ESH hypothesis large banks, in terms of profitability, performs well as compared to small banks for reasons they are more efficient than small banks. 5 SBP has now laid minimum rate on PLS accounts with effects from June 1, 2008. Source: [email protected]
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Although the banking sector during decades of its operations after deregulation has shown remarkable performance it has not been researched whether the market has been competitive and contestable, that is no research to date has been done to assess nature of competition in banking sector of the country and to test whether the sector is in long run equilibrium. This paper is
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expected to benefit banking sector itself, the central bank and policy makers in the future. This paper in addition will help policy makers whether to bring changes in regulatory environment so as to ensure competition in banking sector, subsequently to achieve financial stability.
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3. Literature Review
Various approaches have been employed to measure and quantify competitiveness of banking
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sector (Rosse-Panzar, 1977; Lau 1982, Bresnahan, 1982 and Panzar and Rosse, 1987; Boone, 2008).These methodologies, specifically Rosse-Panzar (1977) and Panzar-Rosse (1982), have also been extend to industries other than banking (see Ashenfelter and Sullivan, 1987; Fischer and Kamerschen, 2003; Li and Marinc, 2016), however with criticism on the H-statistic (see Shaffer 1982a, 1982b; Hyde and Perloff, 1995; Shaffer and Spierdijk, 2015). A number of studies conducted in different countries by employing different methodologies
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indicate banking markets operate under monopolistic competition (see for example, Nathan and Neave, 1989; Molyneux et al., 1994;Hondroyiannis et al., 1999;Belaisch, 2003; Claessens and Laeven, 2004; Al- Muharami et al, 2006; Mathews et al, 2007; Al-Muharami, 2009). The study of Bikker and Haaf (2002) finds that banks in EU are characterized by monopolistic competition
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and that the competition in local markets is weaker6 and stronger in international markets. Testing for an impact of consolidation on competition in banking sector of Korea revealed that
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the sector has not been impacted (Park, 2009). De Bandt and Davis (2000) on the other hand find that in Germany the banks operated under monopolistic competition and in case of France the small banks exercised monopoly. The investigation of Arab Middle Eastern banking sector (Murjan and Ruza, 2002) and the banking industry of eight countries in Latin America and Europe (Gelos and Roldos, 2002) by employing P-R methodology indicate the banking industry operate under monopolistic competition.
6
Caminal and Matutes (2002) argue that when banking sector is not competitive credit rationing shrinks, loans are larger subsequently enhancing chance of banking sector failures.
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The results of Lerner (Beck et al., 2013) and Lerner and Boone (Clerides et al., 2014) indicate declining banking competition during 2000s for many world economies, however the market power has increased in the post financial crisis years. However on employing Bresnahan- Lau model Nakane (2001) concluded that Brazilian banking sector operate under competitive
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condition that is expected to remain in long run. Simultaneously Maudos and Nagore (2005) employ Lerner Index and find a U-shaped relationship between size of the banks and the market power. They indicate a positive link between concentration and market power and that efficient banks exercise market power. In case of Argentina Burdisso et al. (2001) report presence of
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almost perfect competition for the period 1997-1999. Williams (2012) investigated Latin American banking sector for estimation of market power and indicates that competitive condition
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fell over the period 1985 to 1990 although the market operated under monopolistic competition. Although competition in banking sector is beneficial in terms of efficiency, it however induces financial instability (Allen and Gale, 2004). This argument is supported by study of Boyd and De Nikolo (2005) that financial stability is affected by stronger market power exercised by banks which subsequently leads to bankruptcy. The research of Berg and Kim (1998) studied the impact of multi-product operations on competition in banking sector. They examine banks’
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behavior in a segment where retail as well as corporate banks operate simultaneously. Asymmetries in level of competition were revealed by the study which in each segment can be compared to consumers’ characteristics. Similarly Abel and Roux (2016) investigated Zimbabwean banking sector by employing widely used Panzar-Rosse H-statistic to measure
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competition in the country’s banking sector for the period 2009-2010. The findings of the study indicate the banking sector of Zimbabwe operated under characteristic of monopolistic
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competition with H-statistic ranging between 0.46 and 0.56. In other words the H-statistic is neither negative, indicating monopoly situation, nor greater than a unit, indicating existence of perfect competition.
In contrast to measuring competition in the banking sector the study of Barbosa et al (2015) investigated Brazilian banking sector by taking into account multi-product banking operations. The study, in other words, investigated whether or not multi-products offered by banks have impact on market power. The findings show that banks exercise market power if and when they offer classic banking products (loans and credit cards) as well as other banking products
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(brokerage services, insurance as well as capitalization bonds) in contrast to banks that offer only classic banking products. On investigating banking sector of Morocco, by considering five banks holding about 80 percent
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of market’s credit shares, the finding of Fatine et al. (2015) show that the banking sector is not competitive by price/quantity and is characterized by monopolistic competition. Similarly the findings, by employing Panzar-Rosse model, indicates that between 1993 and 2010 the banking sector claim stabilization in competitive level, varying from 0.37 to 0.28, however, indicating
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decline in degree of competition.
Exploring banking sector of Fiji for competition by employing Panzar-Rosse H-statistic the
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findings of Kumar and Patel (2014) indicate that the banking sector of Fiji operate under characteristic of monopolistic competition and that the competition in the banking sector is biased toward monopoly or short-run oligopoly. The H-statistic of 0.254 and 0.180 indicate that the banking sector of Fiji is characterized by lower level of competition. Furthermore the findings show that revenues of the banks are positively impacted by interest expenses, CAR, number of branches and negatively impacted by personnel expenses, firm size, and other
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operating expenses.
On investigating banking sector of India Datta (2005) shows that due to trend of globalization the banking sector competition in the country has improved and the competition in the sector is expected to improve further in the future. Employing Bresnahan-Lau model the results indicate
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the competition in banking sector of India is less than monopoly and more than Cournot oligopoly. Another study by Vesala (1995) by examining competitiveness in Finnish banks over
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a period of eight years, 1985-1992, concluded that higher level of contestability existed for the sampled period. To find evidence of existence of competitiveness in banking sector Spiller and Favaro (1984) researched Uruguayan banking sector and suggested that the response of banks vary to actions of other banks in the same banking sector. The literature review shows that the research on competition in banking market around the globe is abundant; however any research relevant to banking market in Pakistan is rare. The research of Mahmood (2009) and Mirza et al. (2016) respectively as measuring competition in country’s banking sector is not sufficient to justify that the banking sector is competitive. For example the
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study of Mirza et al. (2016) have measured degree of competition in banking sector of Pakistan by explaining quantitatively level of competition in the banking market. Similarly the study used quarterly dataset for assessing degree of competition in the banking sector. This study on the other hand measures nature of competition in the banking sector of Pakistan instead of measuring
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degree of competition in the banking sector. This study is different because in measuring nature of competition in the banking sector requires to test, firstly, whether or not the banking sector is in long-run equilibrium which is not covered in the previous papers. Simultaneously this study overcomes existing discrepancies by employing Rosse-Panzar H-statistic (1977) instead of
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Panzar-Rosse (1982) H-statistics to quantify competitive condition of the banking sector and to test whether or not the banking sector is in long-run equilibrium. Secondly the study employs
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annual dataset to quantify nature of competition in the banking sector of the country. Simultaneously the imposition of MCR and CAR by country’s central banks has enforced banks to merge with larger financially stronger banks to retain banking sector stability and to prevent depositors’ money. The focus on overall banking sector of the country is interesting. Firstly, because the market structure after de-regulations, mergers and acquisitions and establishment of Islamic banks have apparently brought tremendous changes in banking sector, It is therefore of
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utmost significance to assess nature of competition in the banking sector. Secondly, since regulatory measures too have changed since de-regulation it is important to test how competition has varied after de-regulation. Thirdly, any change in Prudential Regulations (PR hereafter) and regulatory measurements have direct and natural impact on banking sector, therefore the study
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calls for investigation of the competitive condition of the banking sector and to examine whether the market is in long-run equilibrium or not.
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This paper therefore aims to extend existing literature to banking sector of Pakistan by first assessing nature of competition in the banking sector and secondly to investigate whether the sector is in long run equilibrium by using annual panel data of 30 sampled banks for the period 2007-2015 by employing Rosse-Panzar H-statistic methodology.
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4. Theory, model specification and data 4.1 Theory Structure Conduct Performance (SCP hereafter) model (Mathew et al, 2007) dominated early studies to identify structure of the market. The assumptions of these studies were that the market
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structure is exogenous that is any change in structure impact conduct of the firm and subsequently the performance of the firm. In these studies profitability was regressed on concentration ratio in these studies and the results, subsequently, suggested a positive relationship between profitability and concentration ratios. The results showed that market power
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is exercised by banks in concentrated markets. Efficient Structure Hypothesis (ESH)on the other hand suggests otherwise; in terms of profitability large banks tend to perform very well as
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compared to small banks because of their efficiency (Mathew et al, 2007). Both SCP and ESH however do not end debate because both of them have deficiencies. For example they both focus only on profitability instead of deviation of output price from marginal cost- it is most suitable theoretical basis for measuring competitive condition (Paul, 1999).
New Empirical Industrial Organization (NEIO) overcomes these discrepancies (Mathew et al, 2007). Two most commonly used approaches in this strand of literature are Rosse-Panzar (1977)
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reduced-form revenue framework and Bresnahan- Lau (1982) respectively. The robustness of RP is higher in small samples whilst an anticompetitive bias is shown by Bresnahan-Lau model in small sample (Shaffer, 2004).
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4.2 Model specification
This study uses Rosse-Panzar methodology to assess nature of competition in banking sector of
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Pakistan. Log linear revenue, as dependent variable, is employed to assess competitive condition in banking sector while log return on assets is used to find out whether the banking market is in long run equilibrium or not.
Multiple non-structural measures (Rosse-Panzar, 1977; Panzar-Rosse, 1982, 1987; Lerner Index, 1934; Boone Indicator, 2008) have been employed to assess competitive conditions in the banking sectors. Simultaneously when it is unfeasible to employ structural measures to quantify
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competitive conditions7, the reduced form revenue approaches are employed to measure and quantify competitive conditions in the form of differentiating conduct of the firm and the market power. Albeit less powerful than structural measures the data requirement in reduced-form revenue models are less stringent and thus minimizes the risk of employing model characterized
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by misspecification (Fischer and Kamerschen, 2003). The non-structural measure known as Rosse-Panzar H-statistic does not necessitate the availability of required data on output and input levels (Martin, 2001), it however takes into account firm-specific rental cost of capital services.
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The empirical estimation is performed in two steps. In the first step the study assesses nature of competition in banking sector of Pakistan and in the second step the study estimates whether banking market is in equilibrium or not. For estimating competitive condition the following
ln
+
ln
+
ln
is total revenue of the bank i in year t,
+
ln
+
(1)
is vector of input price (PL, Price of labor;
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Where
=
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reduced form revenue equation is employed:
PK, Price of capital; PF. Price of fund),
is a vector of bank-specific variable (RISKASS,
ratios of provisions to total assets; ASSETS, total assets; BR, number of branches of each bank to the total number of all banks),
is a stochastic disturbance term. The vectors i and t
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impact overall banking market and
is a of macroeconomic variable (annual GDP growth) that
denotes bank and time in years respectively. Reduced form revenue equation is employed to
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calculate R-P H-statistic. In equation (1), The Rosse-Panzare H-statistic (1977) is calculated from reduced form revenue equation. H is the sum of elasticities of total revenue with respect to each of the bank’s input prices (that is PL, PK, PF).
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The structural measures become unusable due to unavailability of required data for quantifying competitive conditions or when the model adequacy or competency in measuring the competitive conditions becomes questionable.
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The conditions for market to be monopolistic, monopoly or perfect is given in table 1. For testing H-statistic it is important to first test whether the banking market is in long-run equilibrium or not. Therefore to test the market for equilibrium we replace ln
in eq. (1) with
= ′ +
′ ln
+
′ ln
+
′ ln
+
(2)
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ln
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pre-tax profit to total assets. The equation to test for equilibrium is as follow:
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For equilibrium,
=
′ =0
The theory of competitive condition and equilibrium condition (Mathew et al., 2007) is
[Insert Table 1 here]. 4.3 Data Sources
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explained in table 1.
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Yearly annual reports has been collected from individual bank’s website and from the website of country’s central bank, State Bank of Pakistan, spanning over nine years from 2007 to 2015. The study has considered overall banking sector, including commercial banks, Islamic banks,
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specialized banks, and foreign banks. Due to unavailability of required data the study takes into account a sample 30 banks. The data for time series macroeconomic variable annual GDP growth has been obtained from World Development Indicators (WDI), World Bank. The study uses panel data with fixed effects. Fixed effect model is considered more appropriate than random effect model as evidenced by the results of Hausman (1978). To deal with heterogeneity panel data is an effective and appropriate way because; the data is more informative, there is higher variability, collinearity is low or no collinearity is present, the degree of freedom and the efficiency is higher respectively. Hausman test is conducted to whether run
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fixed or random effects. Due to rejection of H0 or in other words acceptance of H1 and significance at 5 percent it is justified to use fixed effects. The results are shown in Table 2.
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[Insert Table 2 here]
5. Results and Discussions 5.1 Equilibrium in banking sector
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For estimating competitive condition in the banking market it is required to test whether the market is in long run equilibrium or not. Because the banking sector over recent years has
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witnessed major changes through mergers and acquisitions non-existence of equilibrium over period of analysis is not a surprise. The results are presented in Table 3: [Insert Table 3 here].
The result of E= -0.10828 indicates that equilibrium hypothesis is rejected for the banking sector over the period of analysis. The equilibrium test was performed to see any impact of explanatory
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variables on ROA. The coefficients of PL (unit cost of labor), PK (unit cost of capital) and PF (unit cost of fund) as -0.019, 0.004 and-0.093 respectively shows that input prices PL and PF negatively impact ROA in the long run. The high cost of labor impacts banks in terms of lowering their returns in long run. Similarly banks that have high cost funds in terms on interest
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payment can cost banks in terms of returns. The positive impact of PK on ROA indicate that if efficient capital is employed then even if cost of capital is higher the banks still can enjoy
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positive returns on assets in the long run. In other words banks that spend more on capital (in other words banks spending more on intellectual capital in the form of periodic training and development of employees) enjoy positive returns on assets. The results show that PL, PK, RISKASS and BR are statistically significant at one percent significance level, PF and ASSETS are significant at 5 percent level whilst GDP is significant at ten percent significance level. The estimated equation has good explanatory power because the explanatory variables show 81.5 percent variation in dependent variable.
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The negative impact of RISKASS on ROA shows that provisions against non-performing loans in the long run affect banking return on assets negatively. This poses two threats to the banks in the long run. Firstly, higher the provisions against non-performing loans the lower the money available for banks in the future to lend to investors. Secondly additional cost is incurred by
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banks when loans are waived off or when borrower defaults on loans. Furthermore the positive relation of ASSET shows that the more the assets banks have higher will be return on assets. However keeping unnecessary branches can have negative impact on banks’ ROA. Although the results show an opposite relationship between GDP and ROA the impact however is negligible.
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The relationship between GDP growth and ROA suggest they both are related to each other as
5.2 Competition in banking sector
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any change in equilibrium will have change in growth of GDP and vice and versa.
By obtaining estimates of equilibrium model we can without any hindrances calculate H-statistic for competitive condition. Our finding of H-statistic of 0.728 is closer to the finding of Mahmood (2009) whose findings are in range of 0.8 to 0.9 but far from finding of Mirza et al. (2016) whose results suggest H-statistic of 0.998. The results of competitive condition are
[Insert Table 4 here].
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presented in table 3.
The results indicate that except PF, RISKASS and GDP the ratios of PL, PK, ASSET and BR are
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statistically significant at one percent significance level. The coefficients of input prices show a positive impact on revenue of the banks. The value of H-statistic of 0.728 shows that banking sector of Pakistan operates under characteristic of monopolistic competition. Cost of labor
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increases when banks open new branches to meet the market demand and to maintain market shares. Opening up of new branches increases every sort of cost for the bank at a rate that revenue at all times exceeds expenses. The value of cost of capital is interesting because it is positively related to bank revenue. Due to induction of professional and qualified staff by banking industry the cost of capital too has risen for banks, however, the relationship is negligible and the impact is minimum. The negative value of ASSET indicates that it may cost 8
The wider deviation between the current study and study conducted by Mirza et al. (2016) could be due to inclusion of overall banking sector or could be due to employment of annual data, rather than quarterly data, for the analysis purpose.
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banks in terms of profitability if they hold unnecessary or excessive assets at hand, thereby impacting future investment and overall economy9. Simultaneously the negative RISKASS shows that revenue of the bank erodes when banks increase provisions against loans. The existence of opposite relationship between REV and GDP is interesting. Any change in
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competitive environment impact country’s GDP growth. The relationship here, however, is negligible. 6. Conclusion and future directions
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The study intended to assess competition in banking sector of Pakistan over the period 20072015 by employing yearly data obtained from websites of respective banks and country’s central
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bank. The study employed methodology of Rosse-Panzar for the sample banks to carryout analysis. The results are consistent with results of Mathew et al (2007) which show that British banking operated under monopolistic competition when Rosse-Panzar(1977) methodology is employed. The results show that banking sector of Pakistan is monopolistically competitive and that the banking market of the country is not in long-run equilibrium which means that major ins and outs are happening in the country’s banking market through mergers and acquisitions. The
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merging of banks and acquisitions by banks show that the dynamics of competition are changing in the banking market subsequently improving overall competition in the banking market. Although competition over years has improved considerably in the banking market it is important to strengthen the banking sector further by further improving regulatory environment
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by minimizing barriers to banks to enter the market. Banking sector of the country should be
•
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further investigated. For example:
A multi-product approach should be used to assess competitive condition because banks in the country over the recent past decade are offering more products to their customers than before which therefore calls for investigation in whether the banking sector is competitive or not.
•
The behavior of commercial banks (conventional versus Islamic bank) should be investigated to find nature of competition and to test whether the market is in long run
9
Banks that keep higher assets at hand are expected to impact banking sector and overall economic growth because when they hold higher unnecessary assets at hand they spent less on investment which subsequently costs overall economy.
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equilibrium for reason that the shares of Islamic banks in the banking sector since its inception has multiplied, so the competition should be quantitatively measured and assess which banking model is more competitive. This sort of investigation will show which mode of banking is prioritized by customers and depositors.
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Due to recent mergers and acquisition against backdrop of requirement of minimum paid up capital and minimum deposit rates by country’s central bank in the banking sector it should be tested whether the mergers and acquisitions in the banking industry has resulted in
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overall economic stability of the country.
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concentrated banking sector and to find its subsequent impacts on banking competition and
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•
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ACCEPTED MANUSCRIPT 1 Table 1. Conditions for competitive banking market
Competitive Conditions H ≤ 1 indicates banking market has monopoly.
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H = 1 indicates existence of perfect competition, natural monopoly or sales maximizing firms.
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0 < H < 1 means market operates under characteristic of monopolistic competition.
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-
Equilibrium Conditions E = 0 shows that market is in long-run equilibrium.
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E < 0 shows non-existence of equilibrium or market is in dis-equilibrium.
Table 2. Hausman Specification Test
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Competitive condition model Equilibrium condition model Chi-Sq stats
43.7530
Chi-Sq d.f
7
Prob
0.0000
38.4558 7
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0.0000
Hausman test is conducted to choose between fixed and random effects.
Coefficient
Standard error
t-stats
Prob.
-0.1179
0.0488
-2.4136
0.0166
Price of Labor Price of Capital
-0.0189 0.0041
0.0042 0.0014
-4.4453 2.9089
0.0000 0.0040
Price of Fund Ratios of provisions to total assets Total Assets
-0.0934 -1.0118 0.0087
0.0463 0.0345 0.0034
-2.0131 -29.2739 2.5652
0.0453 0.0000 0.0109
No. of Branches Annual GDP Growth
-0.0075 -0.0012
0.0028 0.0007
-2.6777 -1.7096
0.0079 0.0887
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Variables C
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Table 3. Estimates of equilibrium, dependent variable LNROA.
R2 = 0.8150 F-stats (Probability) = 28.5174 (0.0000) E = -0.10828
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Table 4. Estimates of competitive condition with dependent variable LNREV. Standard error
t-stats
Prob.
C
3.871
2.1859
1.771
0.078
Price of Labor
0.331
0.1003
3.305
0.001
Price of Capital
0.066
0.0240
2.735
0.007
Price of Fund
0.331
0.2840
1.166
Ratios of provisions to total assets
-0.821
1.8627
-0.441
Total Assets
-0.380
0.1474
-2.580
No. of Branches
0.370
0.1171
Annual GDP Growth
-0.024
0.0176
F-stats (Probability) = 9.2786 (0.0000)
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H= 0.728717
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0.245
0.660
0.010
3.163
0.002
-1.384
0.168
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R2 = 0.5890
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Coefficient