COMPETITION IN THE BANKING INDUSTRY OF THE 21ST CENTURY
Introduction
The banking industry all over the world is facing rapid transformations. Many factors can be attributed to this new trend; these include deregulation of financial services, technological innovations, opening up of to international banks, changes in corporate behaviour, and the growing rate of disintermediation. Additionally, these pressures have been accentuated by the recent banking crises that have hit different banks on the globe. Global banks have also been transformed because of the wave of privatization of State-Owned banks, which had previously dominated the banking industry in the past (Gup, 2003). The paper that follows will attempt to discuss how competition in the banking industry has increased dramatically over the past 20 years. In order to achieve this end, the essay will scrutinise and illustrate the factors that drive bank competition.
The paper opens up with a review of the competition policy in banking followed by a discussion on the forces that drive changes in the banking industry. Following this will be a scrutiny of how these forces are influencing the structure of the global banking systems through domestic mergers, privatisations, and entry of the foreign banks. An analysis of the effect that these factors have on economies of scale and competition within the banking industry will then follow. The paper will also present an overview of the consequences of competition in the banking industry and apply Porter’s five forces of competition to analyse the cutthroat competition that has characterised the banking industry of the 21st Century.
Competition Policy in Banking
There is a general assumption in the banking sector that tends to allude to the fact that banking systems possess a special status. This assumption is founded on the fact that the banking industry is more vulnerable to instability than other industry or sector of the economy. Another fact fuelling this assertion is that banks have many less wealthy shareholders that hold non-negligible shares in form of small amounts of bank deposits. A look at the manner in which banks looks at its assets and liabilities reveal that they use a traditional view. According to this view, banks analyse the profitability and viability of all project proposals presented to them by entrepreneurs prior to their granting loans to these entrepreneurs. Additionally, banks heavily depend on short-term demanded deposits that they receive from their customers (Ratnovski, 2013). They pool these small deposits and invest them in long-term projects. The maturity mismatch between the bank’s assets and liabilities makes the banks crucial providers of liquidity to depositors.
The 21st Century has witnessed close cooperation between banks. Most if not all banks of this century are involved in interbank payment and lending systems. These banks happen to borrow from and lend to each other with an aim of cushioning each other from any liquidity fluctuations that might impede on their daily operations. The modern day banks are also involved in large value transactions on their customers’ behalf. They mediate transactions such as wire transfers from one bank to the other and so forth (Ratnovski, 2013).
The competition policy that affects banks can be classed into three main business practices; mergers, cartels, and abuse of dominant position. Cartels have gained notoriety in distorting, preventing, and restricting competition in the banking industry. Cartels can be formed horizontally between producers and distributors or vertically between producers and suppliers. Anti-competitive cartels are notorious in limiting technical development, markets, productions, and investments within the banking industry. Abuse of dominant position occurs when one or more firms occupying the dominant banks exert some form of anti-competitive behaviour on the market. Mergers can also reinforce a dominant position and enforce anti-competition tendencies on the banking industry (Ratnovski, 2013). It is worth noting at this point that banking has always been regarded as a special sector and as thus, the reinforcement of the competition policy has been left to regulators within the banking industry.
Forces for Change
The cutthroat competition witnessed in the banking sector of the 21st Century can be attributed to forces that include external opening up of local banking sectors to foreign competition, changes in corporate behaviour and crises in the banking sector. These forces are what are said to have occasioned the changes witnessed in the level and intensity of interbank competition. The forces or drivers are briefly discussed hereunder:
- Deregulation and opening up to foreign competitors
Traditionally, the banking sector was highly protected and tightly regulated by governments and other banking regulators. The sector was characterised by pervasive restrictions foreign and domestic entry. This situation persisted for long and it was only challenged by technological inventions and macroeconomic pressures that hit the industry in the 1990s. These interventions and pressures forced the regulators to loosen their grip on the banking sector and allow deregulation that also opened up financial markets to both domestic and financial competition. Consequently, geographical and bank borders disintegrated leading to a build up in competitive pressures among banks in emerging economies (Gup, 2003). This has since led to pronounced changes in the structure and composition of the banking industry. These changes have included privatization of State-owned banks, mergers and acquisitions, increased entry and establishment of foreign banks, and establishment of new financial institutions such as deposit taking micro-finance (DTM) institutions.
- Changes in Corporate behaviour
Corporate behaviour has been influenced by the new capabilities that information technology has afforded the banking industry. Most of the modern day firms use IT in their operations. These technology-dependent firms continuously seek funding for their projects from established lending institutions such as banks. However, most banks are unwilling to finance new technologies because of the element of uncertainty that is attached to such projects. As a means of circumventing this challenge, large firms have turned to the capital market as a source of funding. These firms issue their securities in the stock markets and they acquire loans from the capital markets at better lending rates than those offered by banks (Gup, 2003).
- Banking crises
Serious banking crises that occurred in the markets of the 1990s caused regulators and governments to rethink on strategies that would cushion banks from crises. These crises were more pronounced in emerging economies than in the industrial world. The players in the banking industry were therefore forced to embrace deregulation and entry of foreign banks into the local banking markets to offer the much-needed reprieve for the ailing and crises-ridden banking sector (Gup, 2003).
Consequences of Competition in the banking industry
Some people are of the opinion that competition in the banking sector imparts some effect on economic growth and financial stability. However, not all of the effects are positive; some are negative and they cause problems in the banking industry. Two conflicting school of thoughts exist in the financial system; on the one hand it is argued that economic growth and efficient financial systems results from higher completion. Another school of thought argues that the stability of the banking sector results from monopoly and market power.
Different theoretical models can be used to identify and analyse the effects of heightened competition on the banking sector. Based on competition, banks can be grouped as being perfect competition banks, oligopolistic bank, and monopolistic bank. Monti-Klein model describes a monopoly bank as being one that represents the whole banking industry (Zopounidis, 2002). This model presents the demand for loans as a downward slope and supply of deposits as an upward slope. The banks make their profits by taking the difference between margins on deposit and the sum of loans and management costs. This model implies that the bank margin is reduced when the bank customers, who are the firms and households, get substitutes to the financial products being offered by the bank (Freixas and Rochet, 2008).
Another model is one that relates to perfect competition. According to this model, the bank is considered a price taker and as thus, it equates the firm’s intermediation margin to the management costs’ margin. Consequently, an increase in loan rate emanates from the fact that there is an increase in the supply of loans, while a decrease in the deposit rate depicts a decrease in the demand for deposits (Freixas and Rochet, 2008).
Vives (2001) argues that the perfect competition model of banking sector is not realistic because of the many barriers to entry, information asymmetries, and switching costs. Freixas and Rotchet (2008) vouch for the use of an oligopolistic model that has an infinite number of banks. According to the oligopolistic banking model both the deposit and loan rates depend on the number of banks in the market and the intermediation margin is lowered when the number of banks in the industry increase. This means that as interbank competition intensifies, profits earned from the difference between deposit and loan rates is cut down or reduced substantially.
The oligopolistic model of the banking industry suggests that an increase in interbank competition lowers the rates charged on loans and increases the returns made by depositors. Aside from that, this competition in the banking industry also affects macroeconomic performance in terms of financial stability and economic activity (Khatkhate, 2009). Numerous studies have confirmed the existence of a positive relationship between competition in the banking sector and the level and nature of economic growth. One of such studies asserts that capital formation is often impeded by a monopoly banking system. This assertion is founded on the fact that monopolistic banks have gained notoriety for rationing credit by imposing high interest rates on loans and pay low interest on deposits, and this causes a slower rate of economic growth. Conversely, Dell’Ariccia et al (2001), presents a theoretical model, which demonstrates how higher competition in the banking sector lowers both deposit and loan rates and in turn affect macroeconomic performance by promoting capital accumulation.
Vives (2001) provides another explanation on the effect of increased competition on the efficient allocation, which ensures that credit is offered at the lowest price. This means that in a concentrated market, a bank makes profit by supplying limited amount of credit at higher interest rates. This model has been faulted by those that assert that the model will only hold true if the bank devices a way by which they will be able to distinguish between credit-worthy and bad borrowers.
Smith et al (2003) contribute to the discussion by supporting the existence of a monopoly banking system. The duo argue that young firms stand higher chances of getting loans at lower rates from a monopolistic bank than from banks in competitive environments. The monopolistic bank offers lower rates on loans with an expectation that it will obtain a greater share of the returns obtained by the firm in the future.
The discussion presented in the above paragraphs happens to be contradictory in nature. On one hand, heightened competition is said to allow access to finance at lower rates, drives commodity prices down, and ensures efficiency in resource allocation. These effects work jointly to boost capital formation and accelerate economic growth. Conversely, monopolistic banking is favoured because it ensures financial stability and affords cheaper loans to young firms. However, close regulations ensure that the consequences of high risk taking under perfect competition are checked and incentives aimed at monitoring the borrowers that have been created under monopoly.
Porter’s Five Forces of Competition
It is worth noting at this point that the banking business is huge and almost all banks serve the same customer base and offer similar products. In order to make a profit in the market, banks operating in a perfect or oligopolistic market must position themselves through pricing, product differentiation, promotion, and marketing. Porters’ Five Forces of competition can be applied to explain how banks deal with the competitive nature 21st Century’s banking industry. This is described hereunder as follows:
- Competitive Rivalry
Rivalry is fierce within the banking industry. Banks follow closely the innovations adopted by their rivals. This ensures that the banks maintain their market share. Innovations such as internet and mobile banking have been replicated in all banks. This has deterred customers from changing banks to access the innovated services (Hill, & Jones, 2010).
- Threat of New Entrants
New entrants coming into an already saturated banking industry must be careful on how they enter the industry. Some offer value added services while others offer their products at discounted rates with a hope of attracting customers from other banks. Entrants that were previously businesses such as supermarkets, insurance companies, and cooperative societies use their current client list as a pint of entry into the banking industry (Hill,., & Jones, 2010).
- Threat of substitute services and products
Traditional banks enjoyed monopoly in provision of products and services. However, the 21st Century banks are faced with competition from non-bank financial institutions that provide similar products and services as the banks and at times, they do so in prices that are below the bank rates.
- Bargaining power of buyers
The success of any business hinges on its ability to come up with innovative products and services that address the needs presented by their customers. Failure by one bank to address the needs presented by its customers might occasion an exodus of multiple personal businesses headed to the nearest bank that is both ready and willing to listen to the customers. The departure of many customers at one time might affect the well-being of the bank (Hill,.& Jones, 2010).
- Bargaining power of suppliers
Customers, governments, and international money markets are the suppliers of the money needed by banks. The central banks of countries are responsible for printing money in paper, coins, and electronic forms.
Conclusion
In summary, the banking industry of the twenty-first century has been hit by a wave of change. These changes have been brought about by forces that include bank crises, deregulation, and opening up to foreign competitors, and changes in corporate behaviour. Competition witnessed in banks is expressed through three main business practices i.e. mergers, cartels, and abuse of dominant position. All of these practices exert some effect on the nature of competition that the banking industry undergoes at one time or another. There are three types of inter-bank competition; these include monopoly, oligopoly, and perfect competition. The success of one bank in an industry that has many banks can be determined by analysing the industry by use of Porter’s Five Forces of Competition. These forces include threat of new entrants, competitive rivalry, threat of substitute services and products, bargaining power of buyers, and bargaining power of suppliers. Many more changes will continue to occur as competition between banks continues to stiffen.
References
Altig, D., & Nosal, E. (2009). Monetary policy in low-inflation economies. New York: Cambridge University Press.
Dell’Ariccia, G., Dell’Ariccia, G., & International Monetary Fund. (2001). Bank Competition and Firm Creation. Washington, D.C: International Monetary Fund.
Freixas, X., & Rochet, J.-C. (2008). Microeconomics of banking. Cambridge, Mass: MIT Press.
Gup, B. E. (2003). The future of banking. Westport (Conn.: Quorum Books.
Hill, C. W. L., & Jones, G. R. (2010). Strategic management theory: An integrated approach. Boston, MA: Houghton Mifflin.
Khatkhate, D. R. (2009). Money, finance, political economy: Getting it right. New Delhi: Academic Foundation.
Ratnovski, L. (2013). Competition policy for modern banks. Washington, D.C.: International Monetary Fund.
Smith, B. D., Boyd, J. H., Smith, B. D., De, N. G., & International Monetary Fund. (2003). Crisis in Competitive versus Monopolistic Banking Systems. Washington, D.C: International Monetary Fund
Vives, X. (2001). Oligopoly pricing: Old ideas and new tools. Cambridge, Mass. [u.a.: MIT Press.
Zopounidis, C. (2002). New trends in banking management: With 42 tables. Heidelberg [u.a.: Physica-Verl.
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