Banking competition and banking efficiency

Banking efficiency is another important policy objective that competition is expected to achieve. Accordingly, the impact of competition and pro-competitive policies on banking efficiency is also of paramount importance to regulators, policy-makers and academics.

Two separate theories are discussed in the theoretical literature regarding the impact of competition on efficiency: the competition-efficiency theory which emphasizes the efficiency-enhancing role of competition, and the competition-inefficiency theory, which postulates a negative relationship between competition and efficiency (World Bank, 2012). The literature seems to be much less ambiguous than the one on the competition-stability- fragility debate as most of the empirical literature lends credence to the competition- efficiency hypothesis.

The competition-efficiency theory, also referred to as the quiet life hypothesis, has its origins in Hicks’ assertion that ‘the best of all monopoly profits is a quiet life’. In the case of banking markets the theory would predict that an uncompetitive banking system will enjoy high interest margins and supernormal profits thus providing no real incentives for managers to strive to be efficient. Managers enjoy a ‘quiet life’ on account of their market power, and thus market power and uncompetitive banking systems breed managerial incompetence (Berger & Hannan, 1998). Increased competition in banking however drives down interest margins and profitability and this induces managers to improve operational efficiency so as to reduce cost in order to improve profitability. In this way, competition enhances managerial and operational efficiency (Schaeck & ihák, 2008). Another channel through which competition enhances efficiency is that competition serves as a threat to managers of inefficient banks of losing market shares (Shirley & Walsh, 2000), as there is a re-allocation of market share from inefficient banks to more efficient banks (Boone, 2008b). This could be a direct threat from efficient incumbents or new entrants. Managers of inefficient banks are therefore incentivised to improve on their efficiency. In regards to deregulation-induced competition, it is argued that deregulation reforms open up the market place to new entrants; the superior management practices and know-how brought in by the new entrants will facilitate efficiency through technology and skill transfer.

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The rather less-popular competition-inefficiency hypothesis, on the other hand, suggests that due to perception of ease of customer–switching in a more competitive environment, increased competition might result in less stable and short-term customer-bank relationships. This will amplify information asymmetry which requires additional resources for screening and monitoring of borrowers. Further, there could be limited reusability and value of information on account of the anticipated short-term nature of bank-customer relationships in a competitive environment (Schaeck & ihák, 2008). These arguments suggest a reduction in the value of proprietary information held by banks, and thus banks incur greater costs in customer-retention efforts through huge investments in ATMs, new information systems, and aggressive marketing, which could constrain cost-efficiency.

This theory has however received little empirical support as an overwhelming majority of studies point to increased competition enhancing banking efficiency. The empirical literature on the efficiency-enhancing role of banking competition is extremely vast and it would be impossible to review it in its entirety, so we will focus only on some of the main contributions.

Berger and Hannan (1998) in a study of over 5,000 banks in the US find that banks in more concentrated and uncompetitive markets exhibited lower cost efficiency, lending support to the ‘quiet-life’ effect. The lower cost efficiency is attributable to non-minimisation of costs due to shirking of managerial responsibility, the pursuit of objectives other than profit maximization or managerial incompetence, which is obscured by the high profits resulting from the exercise of market power. (Schaeck and ihák, 2008) also find evidence of the quiet life hypothesis in which competition has a positive effect on profit and cost efficiency in a study of 12,500 banks in the US and ten European countries from 1995–2005. They use Granger causality tests to establish a positive effect of competition on different measures of profit efficiency. The study further establishes that efficiency served as the transmission mechanism through which competition positively impacted financial soundness. In a more recent study of some European banks, and using different measures of competition, the authors find that bank capital and profitability increase as a result of accelerating competition, confirming that competition enhances efficiency (Schaeck and Cihák, 2014).

Ariss (2010) examines the impact of banking competition (proxied by market power) on banking efficiency in developing countries for the period 1999-2005. The results show a significant negative relationship between bank market power and cost efficiency, but the opposite effect on profit efficiency. In other words, when banks enjoy a greater degree of

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market power, they do not manage their costs effectively, but are able to achieve higher profit efficiency levels. This confirms the notion that efficiency suffers in an uncompetitive banking environment due to the high price mark-up over marginal costs enjoyed by banks with significant market power.

We provide a detailed literature review of the impact of deregulation reforms on banking efficiency in Chapter 4. As detailed in that review, most improvements in banking efficiency arising from banking reforms pass through the channel of increased competition, pointing to the efficiency-enhancing role of banking competition.