NATIONAL

UNIVERSITY

OF

SCIENCE

AND

TECHNOLOGY

FOCULTY OF COMMERCE
DEPARTMENT OF BANKING
MASTER OF SCIENCE DEGREE IN BANKING AND FINANCIAL ECONOMICS
NAME OF STUDENT

AARON KUUDZEREMA

STUDENT NUMBER

N01522588D

ADDRESS

NSSA HOUSE, KARIBA

TELEPHONE

0261 2145210

CELLPHONE

0773 501 255/0712 289 276

EMAIL

kuudzeremaa@nssa.org.zw;
akuudzerema@gmail.com

SUBJECT

CBA 5109: BANK OPERATIONS

AND STRATEGY: ASSIGNMENT 1

YEAR/SEMESTER

YEAR 1 SEMESTER 1:1

QUESTION
Critically examine the argument laid out below and contribute towards its resolution,
including implications to the management of bank operations.
From public policy perspective, competitiveness of the banking sector represents a socially
optimal target, since it reduces the cost of financial intermediation and improves delivery of
high quality services thereby enhancing social welfare. Banking competition also promotes
economic growth by increasing firms access to external financing (Beck, Demirg-Kunt,
&Maksimovic, 2004; Pagano, 1993). However, Petersen and Ranjan (1995) show
theoretically that banks wielding market power tend to lend to young firms whose credit
record may be opaque, hence leading to high lending rates. In practice, Cetorelli and
Gamberra (2001) argue that although concentrated banking systems offer growth
opportunities for young firms, there is strong evidence of a general depressing effect on
growth associated with banks exercise of market power and this impacts all sectors and
firms. (Anthony MusondaSimpasa, Competition and Market Structure in the Zambian
Banking Sector African Development Bank Group, Working Paper Series, 2013, p5).
[20 marks]

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Introduction
This essay seeks to critically discuss whether competitions in the banking sector
contributes to a socially optimal target in the economy and whether banking
competition promotes economic growth. However, the above argument will be
analysed against other theoretical views which asserts that although concentrated
banking system offer growth opportunities to younger firms there is also strong
evidence of a general depressing effect on growth associated with banks exercise of
market power which will in turn impacts all sectors and firms. More so, other authors
Peterson and Ranjan (1995) argue that banks wielding market power tend to lend to
younger firms whose credit record may be opaque, hence leading to high interest
rates.
The above argument bears implication to the management of banking operations
and to meaningfully contribute towards the resolution of this argument there is need
to define banking competitiveness in the first place.
Banking competitiveness
This requires to distinguish between general definition of competitiveness; nation
competitiveness and enterprise competitiveness. Nation competitiveness is the
ability to produce goods and services by a nation, that meet the test of international
markets while simultaneously maintaining and expanding real income of its people
over the long term subject to availability of proper macroeconomic policies and good
economic conditions.
Porter (2000) further argues that competitiveness depends on increased productivity
of a nation enterprises, continuous in value addition, therefore enterprises need to
transform from their method of competing, shifting from comparative advantage to
competitive advantages; namely the ability to compete on cost and quality. On the
other hand Altenburg, Hildebrand and Meyer (1998) define enterprise
competitiveness as the ability of the firm to sustain a market position by inter alia
supplying quality products on time at competitive prices through acquiring the
flexibility to respond quickly to changes in demand and through successful managing
of product differentiation by building up innovative capacity and effective marketing
system. Banks compete successfully in markets by building strengths which include
the existence of an established customer base, technical expertise and innovative
ability resulting from specialisation in particular domestic market.
Success in competitiveness depends on size of the institution and capitalisation.
Size of the institution helps to determine whether the bank can take advantage of
economies of scale while capitalisation may affect institution credit standing. Thomas
and Chauseng (2006) view competitive bank as the one that achieves maximum
safety in payment system, efficiency in credit allocation and responds to monetary
and fiscal policy changes while customers view a competitive bank as the one that
can provide customers with highest paying deposits, lowest interest loans, cheapest
and best financial services. Therefore for a bank to be competitive in a market it
needs to balance the above aspects about how it is viewed as a competitive bank
from industry, regulatory and customer perspective. Since it is now clear what

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banking competitiveness mean lets try to find out effects of banking competitiveness
to the financial system and economic growth.
Competitiveness in banking leads to reduction in financial intermediation
costs.
Financial intermediation exist to solve or reduce market imperfections such as
differences in preferences of lenders and borrowers, transaction costs, shocks in
consumer consumption and asymmetric information. Financial intermediaries reduce
market imperfection through asset transformation, transaction cost reduction,
liquidity insurance, informational economies of scale and delegated monitoring.
Financial intermediaries can reduce the cost of channelling funds between borrowers
and lenders, leading to a more efficient allocation of resources. Banks can improve
on a competitive market by providing better risk sharing among agents who need to
consume at different (random) times. An intermediary promising investors a higher
payoff for early consumption and a lower payoff for late consumption relative to the
non-intermediated case enhances risk sharing and welfare. Diamond and Dybuig
(1983)
Competition in banking promotes economic growth by increasing firms
access to external finance
The relationship among competition in the financial sector, access of firms to
external finance and associated economic growth are ambiguous in theory. In
addition measuring competition in the financial sector can be complex. Less
competitive banking system may lead to easier access to external financing because
with more market power, banks are more inclined to invest in information acquisition
and relationship with borrowers. However, banking systems which are less
competitive there is hold up problems that may lead borrowers to be less willing to
enter into relationships, thereby lowering the effective demand for external finanbce.
Stijn Claesens and Luc Laeven (2005) supported for the view that more competition
may reduce hold up problems and lower the costs of financial intermediation, making
financially dependant firms more willing to seek external finance. Boot and Thakor
(2000) suggested that hold up problems occur less often in more competitive
financial systems and because of that firms may be more willing to enter close
relationships with a bank under more competition.
Consequently, with more competition, firms especially those heavily dependent on
external finance should grow faster. It is also likely that under more competition, a
financial system provides a broader range of better quality financial services at lower
costs and in that way improves industrial growth.
However, building on the empirical methodology of Rajan and Zingales (1998),
Cetorelli and Gambera (2001), concludes that banking sector concentration exerts a
depressing effect on overall economic growth even if it does promotes the growth of
industries that depend heavily on external finance. Deidda and Fattouh using the
same data found out that banking concentration is negatively associated with per
capita growth and industrial growth but this only applies in low income countries and
there is no such significant relationship between banking concentration and growth in
high income countries.
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On the other hand with Industrial organisation approach assessing the degree of
competition in financial sector allows one to overcome the concerns above. The
Panzar and Rose (1987) methodology provides better and supported measure of
competition, which model has also been used to estimate the competitiveness in
banking industries. The methodology of Rose and Panzar (1977), as expanded by
Panzar and Rose (1982) and Panzar and Rose (1987), now denoted PR use data at
firm (or bank) level. It investigates the extent to which a change in factor input prices
is reflected in equilibrium revenues earned by a specific bank. The PR H- statistic is
calculated using reduced form bank revenue equations and measures the sum of the
elasticitys of the total revenue of the bank with respect to the banks input prices.
However, the structure of the banking sector has been an issue of policy interest
focused largely around a presumed tendency towards concentration and its effects
upon economic efficiency, bank profitability and macroeconomic stability. There has
been greater tolerance of concentration in banking than in other industries because
of presumed benefit of increased financial stability.
Bank concentration and market power
Economies of scale and scope will lead to concentration in the banking sector and
dominance of the financial sector by a few large entities. Significant consolidations in
the banking industry, accompanying the new electronic technology has reinforced
concerns of economies of scale. Anticipated cost savings or reduced risk due to
diversification are generally advanced as rationale for bank mergers to gain potential
in exploiting market power and depositors perception of increased safety.
Concentrated banks survive even when not performing well due to that government
may deliberately be unwilling to allow the failure of large banks. Berger et al (2007)
argues that technological developments have changed the underlying economics of
banking in such a way that some of the negative effects of increased size have
diminished. These includes changes in service delivery methods, information
processing techniques that smaller institutions possess in closeness and relationship
with its customers.
Having the motivation leading to concentration and dominance by banking industry
there is need now to analyse argument posed by Petersen and Ranjan (1995) that
banks wielding market power tend to lend to young firms whose credit record may be
opaque, hence leading to high lending rates.
Since interest rates affect the probability that financing spurs growth, it would be
useful to know what factors cause high interest rates. May be interest rates are just a
result of a lack of competition in the credit market. Therefore at this stage lets try to
analyse underlying theories to support the argument.
Structure Conduct Performance Theory
When analysing interest rates, mainly the aspect one should consider is that whether
interests rates follow a behavioural pattern consistent with level of competition
financial firms face. While structure conduct performance theory asserts that
competition among lending firms or institutions bring interests rates down, the
argument is weakened by the informational problems that surrounds credit market
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transactions. There are suggestions from other authors that predicts negative
correlation between market power and interests rates. Petersen and Ranjan (1995)
found that lending institution who wield market power are those with enough
resources to invest in relationship lending. The likelihood that small firms will be
granted loans is greater as market power increases which will result in interest rates
decline. Maquez (2002) and Macintosh and Wyclick (2005) arrive at the same
conclusion that as competition among financial institutions increase, default risks
may follow a similar path so does interest rates. However, Boot and Thakor (2000)
claim that relationship orientation helps to partially protect the financial institution
from competition, Hence, higher competition may cause financial firms to reallocate
resources towards more relationship lending therefore smaller firms may face a
reduction in lending rates. Two conflicting hypothesis regarding the effects that an
increased competition on credit markets for small firms have on interest rates is
found when using theoretical literature.
The structure conduct performance framework may misleads if market contestability
is a significant feature. Otherwise if borrowers lack formal documentation to certify
their income and expenditure flow, it is very likely that financial institutions may need
to develop special techniques to assess the risk profile of these potential borrowers.
In a situation like this, an entrance threats is not necessarily justifiable and what
could be considered most is the issue of market contestability and its effect on
interest rates. Consequently, it is not clear cut what effect is the interaction between
entry, competition and interest rates have on credit market.
Empirical literature analysis
Correlation between market structure and interest rates does not matter is positive,
negative or null, it is a question to be solved empirically. Review of empirical
literature shows that there are conflicting results. Certainly, the results depend on the
methodology being used and database characteristics. Boot and Thakor (2000) and
Ongeng and Smith (2000) supports the traditional structure conduct performance
hypothesis, however findings of Patersen and Ranjan (1995) and Zantskie (2003)
support an alternative hypothesis.
If market power is defined by the Lener index, the results support the conventional
theory, greater market power implies higher interest rates, however if market power
is defined by concentration indexes the results are opposite and conventional theory
is discarded. Interest rates are not only determined by real or potential competition,
other characteristics of borrowers and lenders also matters.
Rosemberg, R, A. Gonzalez and S Narain (2009) and Gonzalez (2010), suggest that
tiny loans with very low default rates require higher administrative expenses which
appear not to be offset by economies of scale. According to them administrative
costs are the single largest contributor to interest rates.
The findings above though may be more appealing, but the authors did not explain
how they arrived to such conclusions, there is no information regarding the
econometric model being used nor what other explanatory variables were
considered nor anything regarding the statistical significance of their results.
Consideration should be taken into account also say a manager of a financial
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institution may have a profitable goal which allows him/her for example to enlarge
the portfolio and/or increase the number of borrowers, create branches and recruit
more staff and the characteristics of the market in which they are results in an
optimal pricing policy comprising a loan size within a time scale that they are willing
to offer. If such a framework was to reflect what happens in real terms then it could
be more rationale to jointly estimate a set of equations than one equation at a time.
Competition, Concentration, growth and Stability in banking- A Trade-off
Historically, relatively high levels of concentration in banking have been tolerated, or
even encouraged by governments, based on a view that a less competitive banking
sector may be less prone to banking failure and crises, and more conducive to
financial stability. There has been a view, often unstated, that there is a trade-off
between the efficiency benefits of increased competition and the risk of instability in
the financial sector arising from reduced concentration.
A number of arguments have been advanced in support of that view. First, larger
banks may tend to be more diversified in terms of both geography and products,
reducing the inherent risk of failure. Second, larger banks may be better able to
implement sophisticated risk management systems, which increase their ability to
measure and manage risk-taking vis--vis smaller banks. Third, higher profitability
arising from lessened competition generates a franchise or charter value exceeding
book value (Keeley 1990) which, because it depends on the ongoing survival of the
bank, acts as a disincentive to excess risk-taking. Fourth, a smaller number of larger
banks may be easier for regulatory authorities to effectively monitor and may involve
less risk of contagion.
As Beck, Demirg-Kunt and Levine (2003) point out, there are equally plausible
counter-arguments. The systemic importance of large banks may induce a too-bigto-fail attitude in governments, with the implied guarantee of survival leading to
excessive risk-taking. Market power may also enable banks to charge higher interest
rates on loans, possibly inducing greater risk-taking by their borrowers. Big banks
may be more opaque, and internal control systems may become less effective with
large scale.
There have been many empirical and theoretical studies examining one or more of
these aspects. Allen and Gale (2004, 2007) review and develop various models of
banking markets which focus upon the implications of inherent characteristics such
as imperfect information, incomplete markets and incomplete contracts for the
optimal characteristics and structure of the financial sector. Given the limitations
imposed by those inherent characteristics, constrained efficient outcomes can
involve financial sectors characterised by some degree of concentration and
probability of financial instability. Different models they consider produce a variety of
conclusions, but there is no general conclusion that greater competition increases
financial instability nor that regulatory measures aimed at reducing financial
instability increase welfare, since by distorting financial market structure and
activities they can reduce static efficiency associated with the constrained efficient
market structure.

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The empirical literature has produced mixed results, partly reflecting the fact that
there is relatively little correspondence between measures of bank concentration and
competition or contestability. Because a concentrated market may be highly
competitive, hypotheses about stability based on arguments about competition
effects cannot be satisfactorily tested using data on market concentration.
One alternative is to consider the effect of banking consolidation on both individual
bank risk and systemic risk as was done in the major study by the world bank G10
(2001). They conclude that the potential effects of financial consolidation on the risk
of individual institutions are mixed, the net result is impossible to generalise, but that
most risk reduction potential would appear to stem from geographic including
international diversification. At the systemic level, the net effects of consolidation are
also difficult to identify, but they point to increased importance of issues such as;
greater difficulties in achieving an orderly exit of large complex banking organisations
and the risks of implicit adoption of a too-big-to-fail approach, increased
interdependencies between large institutions, and increasing opaqueness of large
banking institutions and thus potential for a reduced role for market discipline despite
increased disclosure. There is also apparent evidence of increased
interdependencies between large banking organisation in the US, as reflected in the
increased correlation between bank share prices accompanying increased
concentration and consistent with other indicators of interdependency such as
interbank lending and derivatives activities. Increased correlation between share
prices of the major banks has also been identified in Australia (RBA 2006), but
attributed there to common profit experience rather than reflecting increased
interdependencies.
Beck, Demirg-Kunt and Levine (2006) focus on the relationship between
concentration and crises. They estimate how the likelihood of a financial crisis
depends upon various banking system, regulatory and country characteristics for a
sample of 69 countries over the period from 1980 to 1997. They find no evidence
that increased concentration leads to greater banking sector fragility but that stability
is higher in countries where regulations preventing entry or a wide range of activities
are lower and where institutional conditions are conducive to competition. While their
findings are consistent with the concentration-stability view, they suggest that the
importance of competition indicates that something other than a possibility of higher
profitability in a concentrated banking system (and Keeley's charter-value
hypothesis) is responsible.
Another study (Schaeck, ihk and Wolfe 2006) has focused on the relationship
between competition and stability using cross-country data on the occurrence of
crises and estimates of the H-statistic discussed earlier. Their results, using both a
duration model and a logistic probability model to predict the occurrence and timing
of crises for 38 countries over the period from 1980 to 2003, suggest that: greater
competition is associated with lower risk of crisis; higher concentration per se does
not increase the risk of crisis; and a more restrictive regulatory system may
contribute to the build-up of instability.
Recent theoretical literature on concentration in banking has emphasised the fact
that the economic functions of banking need to be considered when assessing what
type of industrial structure is optimal. While competition is generally desirable given
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perfect information, information imperfections which give rise to financial institutions

imply that a market involving institutions with some market power may be optimal.
Associated to this is the fact that banking technology may involve economies of
scale, leading to the emergence of large institutions as the most cost-effective
operators.
Boyd and De Nicol (2005) argue that increased banking sector concentration may
lead to lower interest rates on deposits and higher interest rates on loans, but that
the latter effect would induce borrowers to adopt more risky projects. This potential
response is taken into account by banks in setting their loan rates. Boyd and De
Nicol demonstrate that, under certain assumptions about bank strategic interaction
among others, an increased number of banks leads to a lower overall level of asset
portfolio risk.
Allen and Gale (2000 and 2007) develop models that help to explain the
characteristics of banking market structure which may give rise to contagion. They
consider the ways in which banks are interconnected through mechanisms such as
interbank deposit markets and demonstrate that, in an incomplete network structure,
liquidity shocks that lead to runs on one bank can trigger failures at other banks.
Liquidity shocks in one region lead affected banks to liquidate assets including
claims on other banks in a particular order, with incomplete networks inhibiting the
countervailing adjustments involving other banks which might otherwise occur.
These models do not provide conclusions on whether contagion or financial
instability is related to banking sector concentration, but highlight the fact that careful
analysis of inter-linkages within the financial sector is crucial for understanding the
transmission and ultimate effects of shocks to the system.
Competition in the banking market has been at the centre of the policy debate on
financial stability. As in other, non-financial, markets competition is often seen as prerequisite for an effective banking system. Several theoretical and empirical studies,
however, have shed doubts on the above proposition, claiming that monopoly rents
give banks higher incentives to invest in relationships with smaller and more opaque
borrowers. More so, theoretical and empirical studies have not come to a conclusive
finding on the relationship between banking market competition and stability. There is
a belief that excessive competition can lead to fragility and restraints on competition
are necessary to preserve the stability of the banking system.
As a result consolidations has happened both within business lines and also across
business lines, resulting in financial conglomerates that offer commercial and
investment banking, mortgage services, insurance and pension fund services,
example in Zimbabwe is CBZ financial holdings. While consolidation has often been
justified by efficiency and scale of economy arguments, the process of consolidation
and resulting financial conglomerates have given rise to stability concern. Specially,
the size and complexity of these intuitions might undermine proper regulation and
supervision by both markets and authorities; their size and critical role across
different segments of financial systems might make it difficult for authorities to
intervene and potentially close such institutions, a phenomenon known as too-big or
too-important -to -fail.

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However, there appears to be little evidence (Allen and Liu (2007) that very large
banks gain substantial cost savings from increased scale or product diversification
either from mergers or economic growth. On the other hand there is, though, no
evidence that larger banks are less efficient than their smaller counterparts and the
net benefits from geographical diversification from geographical diversification
appear unclear particularly given technological change.

The theory of efficient competitive markets propagates market related prices that will
transcend to a reasonably low bank charges, efficient service provision as well as
competitive market related interest rate as financial institutions seek to increase their
individual market shares. This is consistent with traditional structure conduct
performance perspective of assessing competition in highly competitive markets.
The SCP suggests that the more concentrated a market is the more market power
banks have such that they can get away with inefficiency without being forced out of
the market. According to this view, empirical findings within Zimbabwean financial
services are characterised by high lending rates averaging 20 percent per annum
whereas deposits rates are less than 4 percent per annum or even not attracting
interest at all. Mature and emerging markets in some countries experience lending
rates of about 3 to 8 percent respectively giving questions on the competitiveness of
the banking sector. The high interest rates can be explained by the levels of
sovereign risk associated with Zimbabwe but they also offer an insight into the
competitiveness nature of the banking sector.

Conclusion
Stijn Claessens and Luc leaven (2005) using a large cross section of countries to
measure banking system competitiveness to industrial growth, they found out that
firms dependant on external funding grow faster in more competitive banking
systems. There is no evidence though that market structure, which is concentration
in banking system helps predict industrial growth.
A conclusion was made from empirical tests that there is no support for the view that
market power is good for access to finance. The findings suggest that the degree of
competition is an important aspect of financial sector development and in turn
economic growth.

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