The effect on market share, interest rates and collateral

4.1 Customer mobility

The first test we perform is to verify whether – and to what extent – the entry of foreign players improves customer mobility.

Several studies, focusing on the degree of rivalry within a market, use market share changes as a measure of competitive pressure stemming from either incumbents or new competitors (Caves and Porter, 1978; Davies and Geroski, 1997). Relative stability in the ranking of firms in the market could suggest collusive behaviour (Heggestad and Rhoades, 1976). Likewise, from a theoretical point of view, few movements in market share do not necessarily mean there is a lack of rivalry, i.e. in a perfect competition framework, market shares remain stable. However, this is very unlikely (Shepherd, 1970): even in markets that are not highly concentrated, entrepreneurs will use various strategies to differentiate their products, which leads to movements in market share.

In the banking industry, tight entry regulation reduces market share instability. In Italy, during the last two decades, constraints to geographical expansion and to various activities have been removed. In the same period, several mergers and acquisitions have taken place. Notwithstanding the increased concentration of the market, big banks have suffered from market share losses, while small and foreign banks have improved their positions (Bonaccorsi di Patti, Eramo, Gobbi, 2005). Most likely, reorganizations following M&As have loosened customer relationships (Sapienza, 2002).

In order to isolate the changes not induced by competition, in this section all the indicators have been adjusted to account for mergers and acquisitions among Italian banks in the sample period, by re-building pro-forma consolidated data for banks resulting from the aggregations.

We therefore computed the following (absolute) mobility index (MI) by province and market segment:

[1] MI k, p, t+1 =∑j=1, n | MS j, k, p, t+1 – MS j, k, p, t |

where MS is the market share of the j-th bank in the p-th province at time t (as said adjusted for mergers and acquisitions); n is the overall number of banks operating in the p-th province; k are the market segments considered (loans, short-term loans and mortgages to households or

businesses).9 _{This index has the advantage of exploiting the variability of the distribution as a}

whole.10

The MI index has been regressed as in the following specification:

[2] MI k, p, t+1 =  + β (Foreign Bank market share k) p, t-1 + γ (Controls k) p, t-1 + dt + up + p, t

where dt is a time dummy, and up is unobserved provincial heterogeneity. The estimates take into

account fixed effects at provincial level. The time span runs from 1997 up to 2006; data are yearly averages for 103 provinces. All regressors are lagged by one period, to reduce endogeneity problems. Since the dependent variable is equal to the change in market shares between time t and

t+1, there is a two-year lag with respect to right-hand side variables. Table A2 reports some descriptive statistics of the variables.

The regressor of interest is the foreign banks’ market share. This variable should give a more precise measure of the impact of foreign intermediaries than other indicators such as the number of foreign banks or branches in the market (Claessens, Demirgüç-Kunt and Huizinga, 2001). In fact, as we will discuss in Section 5, foreign banks are involved in retail activities remotely as well (without on-site presence) and other measures could understate the true effect of these intermediaries.

As a control variable, we introduced the Herfindahl concentration index, a common measure for market structure.11 _{We further considered the number of new branches (per 10 thousand}

inhabitants), in order to control both the entry of new banks and the raising of the level of rivalry among incumbents as a result of the opening of new branches.

A measure of indebtedness of households and businesses is also included, in the form of mortgage per capita or total loans over value-added, respectively. The share of small business lending over total loans in the province is considered to capture the dimensional structure of firms in local credit markets and, thereby, the importance of relationship lending.

Credit risk is proxied by the ratio between non-performing loans over total loans to households and firms; markets with lower credit risk should attract more intermediaries and could be associated with a higher degree of rivalry. As a further control, we used the size of the local credit market, which also proxies the degree of financial development; this is computed as the sum of loans and deposits over the population (Kato and Honjo, 2006; Woodrow Eckard, 1987).

Table A3 shows the results in reference to households. Foreign bank presence is positively related to the instability index for mortgages (column [5]), while it is not statistically significant for short-term operations or total loans to households (columns [1] and [3], respectively).

As far as mortgages are concerned, moving from the first to the third quartile in the distribution of foreign banks’ market shares enhances the mobility by 1 percentage point. Since the average mobility index is around 13 per cent, this would account for a 7 per cent increase in the mobility of customers.

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9 _{As far as households are concerned, we do not consider consumer credit, due to the lack of a geographical breakdown before 2002.} 10 _{There is a heated debate on the best indicator to measure the instability of market share, i.e. absolute versus relative or computed on}

the top 3 or 5 largest firms, and so on. See Kato and Honjo (2006) for a recent contribution. For Italy, market share instability in the banking sector is analysed in De Bonis and Ferrando (2000), to verify whether the joint presence of the same banks in different provinces leads to collusive behaviour.

11 _{Other structural indicators, such as the share of the 3 largest banks in the market or the number of banks on the population, produced} nearly identical results.

The retail activity of foreign banks: Effects on credit supply to households and firms 121

We verified the possible different impacts of foreign intermediaries over time. To this end, the foreign bank variable is split into two sub-periods, the first between 1997 and 2001; the second between 2002 and 2006 (Table A3, columns [2], [4] and [6]).

In column [6], the coefficients are statistically similar (with a P-value equal to 0.83 and the F-test equal to 0.05). However, foreign banks recently expanded their activity unevenly across the Italian provinces. As a consequence, the impact between 2002 and 2006 is higher: moving from the 25th to 75th percentile of the distribution of foreign banks’ market share, mobility rises by 1.1 percentage points, almost two and a half times higher than before, corresponding to 9 per cent of the average mobility of the second sub-period.

Among the control variables, greater market concentration (with a higher Herfindahl index) implies higher customer mobility. Other concentration indexes pointed to the same results. This finding is consistent with other evidence on this issue. According to Sakakibara and Porter (2001), when non-price competition is crucial, rivalry in a concentrated industry becomes harder. For Italy, De Bonis and Ferrando (2000) read the positive effect of the Herfindahl index as the consequence of the entry of larger banks into areas where small intermediaries, with high market power, used to prevail.

Developed credit markets offer greater profit opportunities, implying greater customer mobility in all the regressions. The degree of indebtedness has a negative sign; most likely this variable also captures part of the potential risk. The other variables - credit risk or opening new branches - are not significant.

Moving on to look at firms (Table A4), foreign banks seem to exert some competitive pressure on both total and short-term loans (columns [1] and [3], respectively), while there is not any influence longer maturity (column [5]).

For short-term loans, an increase in the market share of foreign banks from the 25th to the 75th percentile amplifies the mobility of firms by 0.4 percentage points, corresponding to 2.8 per cent of total mobility. The effect – although statistically significant – appears small from the economic point of view. This result is consistent with the theory emphasizing the difficulties for new entrants to evaluate firms’ creditworthiness without well-established customer relationships. Our estimates suggest that market shares are basically reallocated in short-term lending, while no effect is detected for loans with longer maturities, usually related to collateralized loans. This further confirms other evidence (see Gormley, 2010) in which a large reduction in business lending to firms with fewer tangible assets is observed following the entry of foreign banks.

The variable measuring small business lending in the provinces has a negative and significant impact, signalling lower mobility in those markets where the presence of small firms is higher and, consequently more relationship lending is needed. Other variables’ results are in line with what has been already discussed for households.

The intermediation of foreign banks is narrow in some provinces; this could affect the significance of some coefficients of the previous estimates. Therefore, we verified the robustness of our results through weighted regressions, where the weights consist of the foreign banks’ market shares in all provinces. Our main findings are confirmed (Table A5).

4.2 Interest rates

As a further step, our analysis focuses on establishing to what extent, and for what products, foreign banks influence the average interest rate charged to customers.

Our dependent variable is defined as the difference between lending rates and the three- month interbank rates, the latter approximating the cost of internal funds for the bank. Ceteris

paribus, a decrease in this differential, associated with an increase in the presence of foreign banks,

would point to an improvement in market competition. As a robustness check, we consider the differential between the lending and deposit rates applied in each province. This variable has the advantage of measuring the spread in each province; on the other hand, interest rates on bank liabilities are reported only for sight deposits, a source of funding not usually correlated to medium and long-term lending.12

For households, we take the interest rates applied to mortgages for housing purchases. As far as business lending is concerned, interest rates are defined as follows: i) the interest rate on overdraft facilities generally used by bank as the reference rate on short-term uncollateralized loans; ii) the interest rate on medium and long-term (usually collateralized) loans. The interbank rate is equal to the yearly average of the three-month Euribor rate.

We want to test whether competition from foreign players has an impact on provincial rates either directly, through more aggressive credit policies, or indirectly, forcing other banks to reduce their prices to retain customers. However, our database allows us to detect only the spillover effect

on the average rates applied in the province. Data on interest rates come from a survey that, until 2004, was limited to a sample of about 70 intermediaries, none of which was a foreign bank. Since 2004 onwards, the sample has been enlarged to about 250 banks (Bank of Italy, 2003), but very few foreign intermediaries were included. At the end of 2005, foreign banks accounted for only 2.2 per cent of mortgages to households reported in the survey; for businesses, the coverage was even lower, equal to 1.6 per cent for long-term loans and 0.3 per cent for short-term loans. Therefore, we are not able to verify if these intermediaries follow more aggressive credit policies and apply lower interest rates; we can only assess whether their presence induces incumbents to react to greater competitive pressure which leads, on average, to lower interest rates.

To test this hypothesis, we used a simple specification where lending rates – in difference to either Euribor [Eq. 3] or deposit rates [Eq. 4] – are a function of foreign banks’ market share (in the province and market segment analysed) and other control variables, according to the following equation:

[3] (Interest rate on loans k -Euribor)p,t =  + β(Foreign banks market shares k) p, t +

γ (Controls k) p, t + dt + up + p,t

[4] (Interest rate on loans k – Interest rate on deposits)p,t =  + β(Foreign banks market shares k)p,t +

γ (Controls k)p,t + dt + up + p,t

where dt is a set of annual dummies, up is the unobserved heterogeneity at the provincial

level. The subscript k refers to the separated regressions related to: mortgages to households, overdraft facilities and long-term loans to firms. Data cover the period from 1997 to 2006.

Equations [3] and [4] contain a complete set of time dummies to take into account cyclical effects not caught by other variables and to which the banks usually react with changes in the

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12 _{However, Kok Sorensen and Lichtenberger (2007) use deposit rates as a proxy of the cost of funding when explaining the dispersion} in interest rates on mortgages across countries in the Euro area.

The retail activity of foreign banks: Effects on credit supply to households and firms 123

margins. As before, further differences across Italian geographical areas, for which we do not control adequately, are captured using fixed effects at the provincial level.13

We use the same regressors already discussed in the previous section. Again, all the right- hand side variables are lagged by one period, to limit endogeneity problems. As previously discussed, since data on interest rates on lending do not include foreign banks (at least up to 2004), this further reduces the simultaneity issue that could arise between market shares held by foreign intermediaries and interest rates.

We expect that the effect on interest rates stemming from the presence of foreign banks to vary according to the market segments where these players compete: if foreign banks compete on the same line of business with domestic banks, interest rates should be systematically reduced (Martinez Peria and Mody, 2004). On the other hand, greater competitive pressure could drive domestic banks towards opaque markets, where they have an information advantage and charge higher interest rates. The result could be an increase in the average interest rate applied by incumbents, due to a change in the composition of their customers (Dell’Ariccia and Marquez, 2004). If this is the case, even an interest rate reduction to a good borrower would be difficult to identify in aggregated data and the foreign presence could be associated to a positive effect on average interest rates charged in the province.

Tables A6 and A7 report the results.

As for mortgages, a greater presence of foreign banks reduces the average spread (Table A6, columns [1] and [3]). When the market share of foreign banks moves from the 25th to the 75th percentile of the distribution, the spread between the lending rate and the Euribor decreases by 15 basis points. The results are very similar when the dependent is defined in terms of the difference from deposit rates (about 13 basis points). Furthermore, although the coefficients of foreign banks in the two sub-sample periods are very similar, the impact of their presence is stronger between 2002 and 2006 (column [2]): moving from the 25th to the 75th percentile, the spread decreases by 18 basis points, a reduction that is nearly double that detected in the first period.

This result is consistent with the arrival of foreign banks specialized in housing finance. In the meantime, the growth of the Italian real estate market has boosted households’ indebtedness. Competition in the mortgage market has intensified: innovative contracts have been introduced – especially by foreign banks – and the range of available products has widened. The use of credit scoring techniques could have contributed to these developments (Albareto et al. 2008); these techniques have turned mortgage contracts into a relatively standardized product, making the entry of foreign intermediaries easier.

Among the other regressors, the Herfindahl index is always statistically significant and positively correlated to interest rates.14 _{New branches boost competition and reduce interest rates}

on mortgages. Household indebtedness (mortgages per capita in the province) does not affect the spread between lending rates and the interbank rate, but it leads to an increase in the spread with deposit rates (Table A6, col. [1] and [3]), in line with other empirical evidence (Kok Sorensen and Lichtenberger, 2007). Financial market development and credit risk (non-performing loans over total loans) do not have significant effects on interest rates.

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13 _{Data on value added, employment rate, and so on, at a provincial level, are available with a high lag. Notwithstanding the loss of} observations, using these variables we do not detect any significant differences in the estimated coefficients.

14 _{The expected sign of the Herfindahl index is ambiguous and it leads to a different interpretation (see Berger, 1995, for a review).} Empirical evidence for Italy is mixed, too; Focarelli and Panetta (2003) find that concentration is significant, reducing deposit rates; on the contrary, it does not affect interest rates for Bofondi, Bonaccorsi di Patti and Gobbi (2006), while it is significant for Fatica, Fiori and Piersante (2006).

For business lending, the activity of foreign banks does not exert any statistically significant effect on the interest rates applied to firms (Table A7, col. [1]-[8]).

On the other hand, well-developed financial markets reduce interest rates on short-term lending, while the coefficient is not significant on long-term lending.15 _{The Herfindahl}

concentration index is not statistically significant, while opening up new branches reduces the interest rates applied to medium and long-term loans to firms. Furthermore, the greater the share of loans granted to small firms in the province, the higher the interest rates applied, due to a high degree of opaqueness and the consequent difficulty of the market to evaluate creditworthiness. Credit risk increases the short-term interest rate while it is not significant on the long-term rate. The latter is affected by the degree of firms’ indebtedness, a result that could catch part of the potential long-term default risk, which is not well controlled by non-performing loans. The degree of firms’ indebtedness in the province is negatively correlated with short-term interest rates, most likely behaving as a proxy for the development of the local financial market.

In our data, lending rates are reported only for loans larger than €75,000, giving rise to a

censoring of small lending which could bias our estimates. To address this issue, we added, to the

previous equations [3] and [4], a proxy for the coverage of the reported data in the survey, built as the ratio between the amount of loans reported in the survey and the actual stock of loans (of the same type and in the same area) reported by Bank Supervisory statements. The results, both in direction and in size, do not change.

Our conclusions are confirmed also by weighted regressions (Table A8), where the weights are computed as the foreign banks’ market shares at the provincial level.

4.3 The collateral required

Foreign banks could compete with domestic banks on other features of the loans rather than in terms of interest rates, for instance by adopting a different policy for the collateral required. As a result, the collateral could be reduced as a reaction to the increased competition, or it could be raised as a device to screen good customers to whom lower interest rates could be offered (Sengupta, 2007).

To verify these two opposite hypotheses, in the following regression we used the share of