Empirical Testing of Competitive Conditions in Banking

1. Empirical Testing of Competitive Conditions in Banking

2. Outline • Scale and Scope Economies • USA Studies • UK Studies • EU Studies • S-C-P Testing • Contestable Markets • DEA Studies on Efficiency

3. Scale and Scope Economies (USA) • Shaffer and David(1991) tested for the presence of economies of scale for very large US multinational banks. • Traditional production cost function used with and without hedonic terms (qualitative factors). In the absence of hedonic terms they found evidence of positive scale economies. • In the equation with the hedonic terms included, economies of scale were reduced from the level without hedonic terms.

4. Scale Economies (USA) • Humphrey(1992) obtained estimates of scale economies for US banks of a multitude of sizes. • the intermediation measure of output was initially used. • His study results suggest diseconomies of scale for all sizes of bank. • However, when alternative measures of output (production approach) were used, Humphrey found significant economies of scale for small banks, constant costs for medium sized banks and scale diseconomies in large banks.

5. Scale Economies (USA) • This study however raised an important question. • Which measure of output should be used? • The author suggested that stock measure was more accurate than flow measure of output. • The study overall results suggest there are slight economies of scale for small banks, but slight diseconomies for large US banks.

6. Scope Economies (USA) • Gilligan and Smirlock (1984) study supported the hypothesis of economies of scope. • Mester(1987) concluded there was no strong evidence to either support or refute the presence of economies of scope. • Lawrence (1989) reached similar conclusions • Hunter et. al.(1990) found no evidence of cost complementaries.

7. Scale Economies (UK) • Hardwick (1990) tested for scale and scope economies using UK building society data and a marginal cost approach. • Overall economies of scale were found - except for very large building societies, where strong diseconomies were present. • Drake (1992) found no evidence to support this.

8. Scope Economies (UK) • Hardwick did not find evidence either for or against economies of scope for large building societies. • However, he found significant diseconomies of scope for building societies with assets worth £1.5 billion or less. • The results of the study showed no case for diversification of most building societies into broader banking market. • Drake (1992) largely agreed, but found that building societies with assets in the range of £500m-5 billion displayed diseconomies of scope.

9. Scale Economies (EU) • Altunbas and Molyneux (1993) examined the cost structure in four European countries (France, Germany, Italy and Spain). • Italy – economies at all levels of output. • Spain – economies only for smallest banks. • France – economies at all levels of output. • Germany - diseconomies of scale at all levels of output.

10. Scope Economies (EU) • Italy - diseconomies for all sizes. • Spain - scope economies evident for banks with assets of < $1.5 billion. • France - middle sized banks showed economies of scope. • Germany - largest banks showed scope economies, smaller banks showed diseconomies.

11. S-C-P vs Relative Efficiency (USA) • Berger and Hannan (1989) conducted direct tests of the SCP and relative efficiency models. • The concentration variables were found to be negative, implying more concentrated the market the lower the rate paid on deposits (consistent with SCP). • Jackson (1992) that ‘price’ is a non-linear U shape. This supports the relative efficiency model.

12. S-C-P vs Relative Efficiency (EU) • Molyneux and Forbes (1993) tested the SCP vs relative efficiency hypothesis using European data. • The authors agreed with Berger and Hannan • They concluded that the SCP hypothesis is supported by this European sample.

13. Contestable Banking Markets (US) • A contestable market is one in which sunk costs are largely absent. • This implies will set price according to marginal cost and consumer surplus will be maximised. • Shaffer (1982) used Rosse-Panzer Statistics to test for contestability in US banking. He concluded that banks in the sample behave neither as monopolists nor as perfect competitors in the long run. • Nathan and Neave (1989) concurred with this conclusion for the Canadian Banking Sector.

14. Contestable Banking Markets (EU) • Molyneux et. al. (1994) tested for contestability in German, British, French, Italian and Spanish markets • The authors found the RPS for Germany, the UK, France and Spain, to be positive and significantly different from zero and unity. • Their conclusion was that in these markets, commercial bank revenues behaved as if they were earned under monopolistic competition. • For Italy, the authors could not reject a hypothesis of monopoly.

15. Efficiency (USA) • Rangan et.al. (1990) used DEA with data from 215 US banks using the intermediation approach of output. • They break down the efficiency score into technical inefficiency (wasted resources) and scale inefficiency (non-constant return to scale). • The study showed the efficiency score of 0.7 implying 30% wastage, all due to technical inefficiency.

16. Efficiency (USA) • Humphrey (1992) measured productivity and scale economies using flow and stock measures of banking output. He obtained measures of total factor productivity by using 202 US banks.  • Banking productivity had been flat • Only moderate increase in TFP

17. Efficiency (UK) • Field (1990) applied DEA to a cross section of 71 UK banks. The results were that 80% were found to be inefficient due to scale inefficiencies. • Drake et.al. (1991) used DEA to analyse building societies in 1988 after deregulation in 1987. 37% of these societies showed increase in their overall efficiency post-deregulation.