Thoughts on Entry Regulation, Financial Market Competition and Financial Crisis

Table of Content

List of Figures

List of Tables

List of Abbreviations

1. Introduction

2 .Thoughts on entry regulation and competition
2.1. The impact of bank competition on risk taking
2.2. The new approach of Boyd and De Nicoló
2.2.1 The outcome
2.2.2 Assumptions of Boyd & De Nicoló
2.2.3 Optimisation from the borrowers’ perspective
2.2.4 Interpretation and assessment

3. Entry Regulation
3.1 My own index for entry regulation
3.2 Entry regulation in LDCs and SSACs
3.3 Entry regulation in Europe
3.4 Short summary on entry regulation

4. How to measure competition
4.1 Concentration Ratio and Concentration curve
4.2 Evaluating the meaning of concentration ratios
4.3 The “consolidation and concentration wave”
4.4 Examples for high and low concentration
4.5 H-Statistics
4.6 Coherency between H-Statistics and CR5

5. Final thoughts on entry regulation, competition and risk taking

6. Summary

References

Appendix

List of Figures

Figure 1: Examples of different concentration curves

Figure 2: Relationship btw. Number of banks and CR5 in 2001

Figure 3: Relationship btw. Number of banks and CR5 in 2005

Figure 4: Distribution of correlations between concentration ratio and H- Statistic

List of Tables

Table 1: Risk-shifting problem –fully equity-financed

Table 2: Risk-shifting problem, fully debt-financed

Table 3: My own index for assessing entry regulation in different countries

Table 4: Total bank balance in Germany between 2004 and 2005

Table 5: TOP 5 and FLOP 5 in banking concentration 2006

Table 6: TOP 5 and FLOP 5 in H-Statistics

Table 7: The highest deviation for Concentration Ratio and H-Statistics

Table of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

This paper deals with the terms entry regulation, financial market competition and also indicates connections to potential financial crises. Authors in research have been attempting for years to build up a remedy for an optimal set-up.¹

So, this is the reason I observe a seemingly never-ending discussion between two unofficial parties: Neither the proponents of the concentration-stability view, neither those of the concentration-fragility view will retreat from how to install proper competition in order to ensure stability.

This paper also aims to understand the terms of both parties; their arguments and whether either monopolistic structures or competition are desirable in the financial industry.

Therefore, I lay the theoretical foundation. I demonstrate with a model of the authors Boyd & De Nicoló that even economies with monopolistic structure are exposed to risk-taking activities – and not only banks in competitive industries. In chapter 3, I turn to the topic “Entry Regulation”. I unveil different yardsticks of entry regulation, reveal some advantages and draw up my own index. I show that mainly countries that suffered devastating crises in recent times have stringent entry regulation. This can be shown by regarding their high capital requirements or their barriers for submitting information of managers, future plans or composition of shareholders. I also show that entry regulation is an appropriate means for governments to control or to curb competition. In the last chapter, it is also shown that high entry capital requirements prevent mainly weak or inefficient banks from entry.

In chapter 4, I present two ratios for assessing competition: The concentration ratio (CR) and H-Statistics (H). CR is widely used in literature and defines the market share of the largest banks in a country. By presenting CR, I also turn back to the argument between the concentration-stability and concentration-fragility views. Moreover, I do my part to debilitate the somewhat misleading statement that the European banking market is in a phase of consolidation and concentration. I do this by revealing that the concentration ratio slightly decreased in a time span of four years during the current decade. H-Statistics is a ratio to find out more about the ferocity and contestability of a market and how market participants react to changes in output prices. I show that there is, maybe surprisingly, no strict correlation between CR and H-Statistics.

2 .Thoughts on entry regulation and competition

The introduction of my work shall be underpinned by an informative and innovative thought on financial competition. The question is: In which way does higher or lower competition in banking affect the phenomena of risk-taking. I reveal that this problematic has to be differentiated coherently by laying the foundations for my further research.

2.1. The impact of bank competition on risk taking

In this part of the chapter, I examine if a change in competition has a concurrent or adverse effect on risk taking. This part is mainly necessary in order to assess the relevance of competition in banking sector which also plays a role in entry regulation and degree of competition as I develop in the following chapters. As I prove in the course of the paper, competition matters to a great extent in diverse countries and can be measured in different ways.

Some authors widely agree that monopoly or low competition may increase market power and therefore pushes bank profits.² As a consequence, the franchise values of the bank increases and banks have less incentive to take excessive risks. This is mainly substantiated by the fact that a monopolistic bank earns monopoly rent and hence, works much more conservatively in order to avoid insolvency and the loss of this outstanding position.³

Hence, increasing competition might lead to an increasing risk-taking policy in order to boost profits and gain market share.⁴ Furthermore, increasing competition is anyhow regarded to be something threatening as high competition induces higher deposit interest rate and therefore the profits of banks melt down.⁵ Tighter spreads are the outcome in that fierce environment. This results in higher risk-taking activities.⁶

To sum up that first thought from sundry literature, there seems to be no incentive to risk taking when there is a monopolistic player in a bank market and we could conclude that risk taking increases when the number of banks increases cp. Monopoly therefore creates stability due to no risk-taking incentives. This is the concentration-stability view. Its proponents assume a positive link between high concentration and stability.⁷

2.2. The new approach of Boyd and De Nicoló

Up to now, competition has also been modelled in widespread literature as something very restrictive in a sense that only the deposit (or passive) side of a balance sheet was regarded and examined. Only the banks were investors in a sense that they use customer deposits for profitable investments. The asset side of a bank balance (the credit business) has not been regarded sufficiently yet and therefore has been totally neglected by previous research.⁸

Boyd & De Nicoló went one step further by examining the behaviour of bank managers on the asset side. Boyd & De Nicoló do not conceive all previous studies as wrong, quite the contrary. However, they stress that all previous authors had overlooked one crucial point – the asset side and its consequences for risk taking, stability and therefore as a potential cause for a systemic risk.

They eventually found that this effect can be more important than the effect in the deposit market channel.⁹ Their result seems perplexing first. Let us recap their outcomes first and then have a closer look at the model:

2.2.1 The outcome

Monopoly in banking leads to excessive risk taking due to the fact that borrowers now have the incentive to take excessive risk.¹⁰ This has a connection tied to moral hazard and risk shifting problems.¹¹ Now, the investment decision is up to the borrower, not the bank.

The borrower has to endure higher rates which imply higher insolvency costs.¹² Well, it is now worthwhile looking into that issue in detail before continuing.

2.2.2 Assumptions of Boyd & De Nicoló

Let us look at the assumptions of the model: Companies (borrowers) do not have sufficient capital and have to finance their projects through bank credits.

There are three points in time:

- t = 0; Banks choose the deposit volume (and hence, define the deposit and credit interest)
- t = 1; Companies choose the risk and invest
- t = 2; credits and deposits are paid off

- Model has to be solved via backwards induction. This is the case because the bank wants to anticipate the borrowers’ move.

2.2.3 Optimisation from the borrowers’ perspective

Risk shifting refers to an increase of risk exposure. In the case of success, the cash flow increases otherwise it respectively decreases

Let me draw up a simple numerical example¹³:

- All participants are risk-neutral.
- r = 10 percent
- investment = 100.000 €

An investor who has enough money wants to fully finance a project. He can choose one out of two projects:

illustration not visible in this excerpt

Table 1: Risk-shifting problem –fully equity-financed, Source: Wahrenburg, 2005

Investment 1 has a higher pay-off. Now, the investor reconsiders his investment when fully-debt financed. He knows that he has to pay off 110,000 Euros and that he has to finance the project with 100 percent debt.

illustration not visible in this excerpt

Table 2: Risk-shifting problem, fully debt-financed

Source: Wahrenburg, 2005

Calculation for Table 2: In the first, the investor has to calculate: 150,000 – 110,000 = 40,000. The same holds for the second investment in state 1: 200,000 – 110,000 = 90,000 Euros. So, now investment 2 has a higher expected value when fully financed with debt.

This effect “worsens” when the interest rate increases.¹⁴ In monopoly state, when there is only one bank that supplies credits, it can require a high interest rate. This distorts incentives and fully reveals the outcome and message of Boyd & De Nicoló.

2.2.4 Interpretation and assessment

The risk-shifting-problem is diminished when competition increases and there are no incentives for the borrower to change the intended project in period t 1 .¹⁵ This is due to

lower interest rate. This can be easily interpreted by looking at the risk shifting example above. However, lower margins do not have an effect on the risk-taking-behaviour of the bank because the bank cannot choose the risk.

Boyd and De Nicoló reveal that the trade-off between competition and stability of the banking sector is not robust. Consequently, one cannot say that competition in banking generally leads to higher risk taking in the banking system or that competition is a threat in an economy due to an elusive systemic risk. It depends whether one effect outweighs the other.¹⁶ Going one step further, the conclusion of Boyd & De Nicoló is that bank risk taking therefore depends heavily on the size and importance of a credit market in a country. Risk taking incentives can be reduced by the borrower by increased competition in the loan market sector. This would lead to lower interest rate and borrowers’ incentives to risk shifting are diminishing.¹⁷ This is the concentration-fragility view.

Summarising that thought, there is the concentration-stability view. It underpins the fact that few large banks with low competition induce stability in an economy. Vice versa, the proponents of the concentration-fragility view emphasise that virtual monopoly induces risk-taking activities by the borrower. This leads to instability.

3. Entry Regulation

Having laid foundations for my further work, I now turn to the issue of entry regulation. The aim of entry regulations in banking is to guarantee that banks entering the financial sector are well and wisely managed and, in worst cases, to avoid systemic risks.¹⁸ Hence, regulators usually require that owners, current and future managers and directors be educated and prepared enough, draw up a coherent business plan, and that there are sufficient funds to be used to implement operations in a profitable way.¹⁹ Plans and intentions have to be unveiled; capital requirements²⁰ have to be met in order to pursue banking business in a country.²¹ The reasons for these criteria are also due to moral hazard, adverse selection and free-rider problems.²²

In this chapter, I focus on the outcomes of a research undertaken by Gaprio et al.²³ He examined entry regulations in more than 150 countries. I identify the criteria of the most importance for my essay and develop my own index which shall be coherent and cogent to find a conclusion if a country has stringent entry regulations or not. This chapter aims to answer the question: Is it more difficult to establish a bank in Country X than in country Y? And which reasons exist for these results?

3.1 My own index for entry regulation

In order to create a meaningful index for entry regulations in banking, I selected 13 questions of the Caprio-table. Almost all questions in this index are answered with yes or no whereby yes = 1 and no = 0 in my index.²⁴ So, the more “points” a selected country reaches the more stringent one can declare a system as stringent. The questions I chose as a representative extract for my index can be retrieved from the Appendix. In my index, 0 points reflect very “friendly” entry regulation - with lenient and low entry barriers. Strict entry regulations obtain 14 points.²⁵ For my index, I defined countries with 9 or fewer points as laxly regulated. 10 to 11 points reflect an average handling and 12 to 14 points indicate strictness.

Table 3 unveils the following result:

illustration not visible in this excerpt

Table 3: My own index for assessing entry regulation in different countries

Source: own work

Nigeria and Spain rank first in my index. This is a hint for stringent entry regulation in banking and it is by trend more difficult to found a bank in these countries than in other ones.

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¹ See in the course of my paper

² Cf. Boot and Marinc (2007), p.9 or cf. Degryse and Ongena (2007), p.3

³ These claims can be found in working papers of Hellmann, Murdoch and Stiglitz (2000), Besanko and Thakor (1993), Boot and Greenbaum (1993) , Matutes and Vives (2000) and Allen and Gale (2000)

⁴ Keeley (1990) argued that an increasing competition seduced bank managers in the US to take excessive risk.

⁵ Cf. Wagner (2007), p. 2

⁶ See also: cf. Carletti (2005), p.27 or cf. Degryse and Ongena (2007), p.4

⁷ Cf. Degryse and Ongena (2007), p.4

⁸ Cf. Boyd & De Nicoló (2003), p. 1

⁹ Cf. Schnabel (2007), p. 38

¹⁰ Cf. Boyd & De Nicoló (2003), p. 1; Here one identifies the term “concentration-fragility view”. This is the counterpart to the concentration-stability view”.

¹¹ Moral hazard is a famous problem in management and economics. The term “moral hazard” originally comes from the area of insurance. It refers to the prospect that insurance will distort behavior, for example when holders of fire insurance take less precaution with respect to avoiding fire or when holders of health insurance use more healthcare than they would if they were not insured. In the financial arena the specter of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future “bail­outs ”. See: Lilienthal et al. (2007): “Asian Crisis”, p.19

¹² Cf. Boyd & De Nicoló (2003), p.3

¹³ The example can be retrieved in Wahrenburg (2005): „Finanzwirtschaft 2, SS 2005“, p. 36ff.

¹⁴ This can be proven by plugging in 20 percent. The spread between the expected value in both states widens by 5,000 Euros. In State 1, expected value is 30,000, in state 2, expected value is 40,000 Euros.

¹⁵ Cf. Schnabel (2007), p. 36

¹⁶ Cf. Schnabel (2007), p. 37

¹⁷ Cf. Schnabel (2007), p. 37

¹⁸ Cf. Daumont et al. (2004), p. 33

¹⁹ Cf. Daumont et al. (2004), p, 33

²⁰ This is a good possibility to link chapter 2 with capital requirements (cr): cr reduces incentives for banks to invest in higher risk activities. This is also mentioned by Berger et al. (1995). High cr may also be a buffer against losses (Dewatripont & Tirole (1992)). However, this might induce higher credit risk taking (Blum, (1999)). Another drawback is that banks might reduce their lending activities (Brealey (2001)). This is further tackled in chapter 5 when I briefly combine entry regulation and competition.

²¹ Cf. Caprio et al. (2003)

²² Cf. Mishkin (2006), p. 513

²³ Capiro et al. regularly examines and conducts surveys in order to assess entry in banking.

²⁴ In one case, yes and no is reversely meant so that the stricter gets one point.

²⁵ In one question, a country can obtain two points by requiring more than 15 million Euros as entry capital requirement from a new entrant.