The Impact of Bank on the Cost of Financial Intermediation

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Table of Contents

Introduction
Impacts of Bank Regulations
Institutional Setting
Interest Margins
Robustness
Market share
Banks-specific Interest and Concentration
Regulation Restriction
Conclusion
List of References

Introduction

The banking industry over the years has received numerous criticisms due to its impractical theories and policies that prove insignificant to today’s changing economy. While many important theories are crucial to efficient banking structure, authors mentioned in this essay provide background information that help us understand how certain predisposition such as bank regulations, market structure, institutions, and cost of financial intermediation contribute to pressure within the banking industry.

The basic findings suggest theories that define the relationships between concentration and net interest margin no longer prove significant since they are contradictory in nature. To support this analysis, various researchers have gathered data over different countries on individual bank operations to estimate how activities are being operated from which they determine the formular to which profits are calculated.

The research analysis considers the cost of financial intermediation and uses net interest margin to measure banks performances across different levels. Since the research does not employ individual banks data, it appears that large institutions are subjected to criticism of market power performance tests. Also, since the two variables are not controlled; bank concentration and national institutions, the research argues, however, that the measures of concentration capture the efficient structure theory and market power theories. That is, the fraction total assets in national institution determine how banks incomes affect the return on equity The research also observes a relationships between several measures on bank concentration at state level and their average performance and find an existing positive correlation between the two variables. The research hypothesis brings us to the questions to how the analysis should address the absence of variables to control for the efficient structure. Here, the research implies that dominance on market power analysis comes first followed by higher profits, and not vice versa.

Impacts of Bank Regulations

Bank regulations comprise of three different, but related issues in explaining the relation between concentration, institutional and efficiency. To determine their effectiveness, the analysis implies that Cost of intermediation is often determined by bank net interest margins and bank overhead expenditures and that the two variables are dependent to each other. Bank for International Settlement (2001) and International Monetary Fund (2002) in one of their policies argue that banks are required to effectively manage their resources as it determines how well they thrive in the competitive markets.

Market concentration and bank performances have received considerable definitions over the years, and their significant numbers of regulatory changes in the banking industry which help us examine different variables and identify conflicting theories about causes of bank concentration. To provide leverage in market concentration, policy makers should consider whether political influence leads to excess market power of larger banks, a competitive disadvantage to smaller banks. Another conflicting theory is that of regulatory policies and their influence on competition and monopolistic power. It’s evident that when one service provider dominates the markets, they create an environment of supremacy and high prices, and larger banks for this case enjoy this advantage (Bank for International Settlement 2001: International Monetary Fund 2002).

In comparison of market power and bank performances, efficient structure theory argues that more concentrated markets are more profitable since they operate on lower costs and gain greater market structures (Demsetz 1973 & Peltzan 1977). This theory implies that profitability does not correlate positively with banks concentration within certain market structure and when smaller banks are exposed to competitive environment they suffer losses due to their inability to absorb risks. Two different, but related issues highlighted in Engerman and Sokoloff (1997) deserve discussion of the research analysis. First, theories traditionally examine banking markets in the developing and developed countries. Secondly, restrictions that protect powerful institutions thereby affecting bank performances.

In order to mitigate the contradictions of banking theories, the data collected from various databases helps explain the impacts of bank regulations on different levels of the economy, the importance of concentration (if any) and benefits of a strong financial institutions to the economy. The analysis disputes that these dependable variables are very important in shaping the regulations and market structure. Since regulations have a great impact on bank margins and overhead expenditures, policy makers and researchers should address the concentration and performance issues to eliminate the imbalances that exist between developed countries and developing countries (Levine & Laeven 2003).

Levine & Laeven (2003) employ a number of observations from 72 different countries and over 1400 banks of various economic structures to argue their cases. From their studies its clear that banking performance is centered among concentration of power, political and economic power. In their observation they discover that operational expenses vary among institutions and larger banks thrive well in the competitive markets. Their second observation was that smaller banks are forced to compete with larger banks, even though they may only operate within one traditional geographical region. This means that competition with large banks determines the pricing of bank services across the markets, even though the smaller banks may not operate on national levels.

Barth & Levin’s (2001 &2003) replicates analysis with similar data on bank regulations, with further analysis on how it regulates its bank entries, reserve requirements restrictions, and its index of regulatory restrictions. In determining the cost of intermediation in terms of bank concentration, the research asses the fractions of assets held by two banks, Mexico and the U.S. The results indicated that deposits rates paid by larger banks were higher than the ones paid by smaller banks. To reassess these results, the research looks at the theory that requires banks restrictions to reflect only regulatory restriction on competition. Since local concentration measures have positive impact on relationships between banks margins and concentration, policy makers should therefore eliminate regulatory restrictions and market across nations should be able to experience efficient-structure forces. On the other hand, Levine & Laeven (2003) realises negative coefficient on concentration after eliminating regulatory impediments to competition, a contradicting theory to this statement.

In sum, regulations of regulatory restrictions on banking operations and market concentration provides a linkage between banks concentration and bank performance on international level rather than on developing countries analysis. Broader concentration measures indicate that concentration did not increase at the developing countries level, but increased substantially at the international levels. Moreover, several researchers such as (Levine & Laeven 2003) provide evidence to support larger banks banking markets. An analysis of concentration and performance at the international level, even with the efficient structure theory, banking reflects a national definition. The researchers here present important information on changing market structure at a national level as a precursor to the movement toward competition as a relevant market for a number of banking services.

In determining the impacts of institutions on cost of intermediation, the research assess property rights protection and the degree of economic freedom by reviewing bank’s regulatory policies and their impact on bank margins and overhead costs. The analysis obtained here assesses how banks control, measure, regulate and determine the cost of intermediation in allocating and protecting their property rights and how they handle competition (Levine & Laeven 2003).

To develop and determine the role of macroeconomics influences on bank margins and overhead expenditure, the research uses two hypotheses; financial intermediation and regulations, and market structure and institutions to measure how they correlate with one another in competitive markets. Performance of the markets can be grouped into two categories; traditional structure (like one practiced in Mexico) and the relative-market power (U.S). Data obtained from Levine & Laeven (2003) databases predict how inflation can have a great impact on bank’s interest margins. Inflation can only be assessed by examining how banks control their equity market which helps us realise that competition is a determinant factor in market structures as it influences the cost of intermediation. Conclusively, political influences have great impacts on pricing of loans and deposits, a contributing factor to a country’s GDP growth.

Broader concentration measures on diversity of banking institutions may also provide useful information for analysing the relationship between the cost of intermediation and bank regulations, bank concentration and national institutions. In examining performance on state by state analysis, developed countries such as the U.S hosts over 23,000 banking institutions, Japan 4,635, Germany 3,509 while France has 547 and developing countries hold minority numbers. Past research has focused considerable attention to the U.S banking industry, financial legal and regulatory systems and concludes that its strong protection on property rights is owed to the state involvement in banking activities. Another banking theory states that concentration triggers competition. Here, the research argues that concentration includes many factors and policy makers do not provide any evidence to determine the relationship between several measures of bank concentration such as the regulatory restrictions on competition, market power and efficient-structure forces and their effects on competition. The results find robust correlation between bank concentration and competition since larger institutions experience high profits when they dominate the markets (Levine & Laeven 2003, p.4; Jayaratne and Strahan (1996, 1998).

Institutional Setting

The data provided by (Levine & Laeven 2003) examines the effects of bank net interest margins on bank concentration, inflation and specific controls in conjunction with regulatory restrictions. The structure argues that more concentrated markets lead to economic freedom, property protection rights and net interest margins because of lessened competition. The results show that countries where institutional environment is influenced by the government, competition produces lower interest margins since they have the ability to influence pricing and raise profits. The data provided by here shows Mexico to be having lower coefficient estimates, which could mean that its economic freedom would be met if operates on the same level with countries like the U.S. It would require the country to provide an environment that would attract private sectors thereby eliminating net interest margins that exist between the two countries.

Interest Margins

When controlling for institutional environment, bank concentrations are no longer important because their linkage to net interest margins are insignificant. And when controlling for bank-specifics, inflation, regulatory restrictions and property rights, research finds that among all these variables, property rights are the only significant variable to bank concentration as they greatly affect bank margins while inflation and regulatory restrictions have no power at all in determining bank controls. Levine & Laeven (2003) analysis maintains that bank-specific regulations and competition have no additional power on property rights and economic efficiency.

Robustness

A methodological issue employed by (Levine & Laeven (2003) in measuring the extend of bank concentration and regulatory restrictions confirm that employing two variables; overhead expenditure and share bank assets does not show any disparities on how banks determine their overhead costs. On a theoretical proposition, the analysis measures of bank concentration indicate that there is a relationship between several measures of bank concentration and regulatory restriction, which influence the performances of banks within a given State. Moreover, the linkage that links the correlation between bank concentration and return on interest rates runs from increasing bank concentration to increasing bank profitability, subsequently boosting the economy. These observations imply that the market-power is a dominating factor in the banking industry rather the efficient-structure depicted by various researchers and their concentrations rely heavily on their net interest margins and their profitability does not correlate with positively with banks concentrations.

Market share theory requires banks profitability to be determined by specific variable which measures the relative size of the individual banks. The research reports that when controlling market shares, regulatory restrictions have a strong relationship on bank’s net interest margins. The findings are consistence with the theory that provides that concentration increases profitability, and for this case, market shares have positive impacts on large institutions giving them power to increase prices. In consideration to property right, research reveals that market shares have lower net interest margins which in turn renders regulatory insignificant. To this the research concludes that when large institutions monopolise the markets, they charge higher net interest margins which is a disadvantage to smaller banks since they do not have the same resources to compete on the same grounds.

Barth and Levine (2001, 2003) argue that bank’s concentrations in deposits equal their fraction of all assets it owns. Institutions with high concentration levels enjoy high deposits since they have the ability to absorb their risks and customers feel secured in investing their assets regardless of their prices. The research notes differences that occur in national and local institutions in calculating interest margins since they assume different levels of riskiness. To effectively determine how banks calculate interest rates, the study assesses how standards deviation affects the return of assets of individual bank. The analyses for controls for bank profits as measured by return on assets shows that controlling for bank assets does not change the results (Levine & Laeven 2003, p.26). In addition, the research argues that increased profits equalises improved economy, and higher profits lead to greater efficiency.

Banks-specific Interest and Concentration

Levine & Laeven (2003, p.20) replicates the analysis with similar data, finding similar results for calculating regression of net interest concentration on banks-specific interest and their effect on various dependable variables such bank-specific variables, bank concentration and regulatory variables on institutions. The findings also find significant differences for small banks that operate in only local markets. He concludes that larger banks discriminate in calculating their interest rates since they are charged lower net interest margins compared to smaller banks, these results also relate to the fraction of liquidity assets where banks that hold high fractions in liquid assets have lower net interest margins offering them a better competitive advantage over the ones with less. This theory is consistence with the statement that argues that “highly capitalised banks can charge more for loans or pay less for deposits because they face lower bankruptcy risks and banks operating on fee basis to have lower margins” (Levine & Laeven (2003, p.20)

Since the analysis uses net interest margins to measure banks’ competitive advantage, the economic magnitude of both local and national markets do not show such huge differences. For example, if countries that charge high interest rates decided to cut down on their concentration, net interest would reduce significantly and they would be the same level as local markets (Levine & Laeven 2003, p.16)

Regulation Restriction

Further complicating the analysis, the data gathered by Levine & Laeven (2003) supports the theory that stipulates that “restricting entry protects existing banks and allows them to enjoy larger margins” (p.17). To test such possibility, the research should evaluate regulatory variables to determine their impacts on such measures. Such dependable variables include activity restrictions, banking freedom, reserve requirements and fraction of entry denied. Evidence in this research suggests that regulatory restrictions changes significantly at different levels of banking markets. He attributes that observation to an improving economy, stating that increased net interest margins reflect, to a large degree, this extraordinary performance of the economy and countries with complicated bank entry restrictions limit economic development subsequently increasing their margins. An alternative explanation suggest that countries with extensive regulatory restrictions limit banks activities that could lead to increasing concentration and market power subsequently boosting their margins. Policy makers should consider making regulatory changes in the entire banking industry to increase market concentration and bank performance, and if “big” reflects nationality, and “small” reflects local, then they need re-thinking of that long-held view of deregulations of geographical on banking.

Conclusion

The tremendous growth experienced in the U.S banking industry in the past decades was initiated by competition within the banking industry. The research notes that this country offers flexible rules to banking activities which increases their freedom to engage in traditional banking business which could have significant results on bank net interest margins. Competition adds pressure to the process of regulations and increases banks efficiency and decentralisation. It would serve a great economic significant if regulatory restrictions were lifted on developing countries leaving banks to thrive on free economic factors which could bring them to the same level as the U.S sound banking structure. And since bank overheads cannot be viewed in isolation from the entire institutional framework, it would be insignificant if policy makers would consider other variables that inhibit finance intermediation and act on them appropriately.

When the research examines the evidence on the relationship between protection of private property rights and economy freedom, when controlling for bank regulations the analysis finds conflicting theories that does not explain cross-bank differences that exist in net interest margins. Moreover, linkage runs from increasing bank concentration to increasing profitability, and net interest margins does not provide any linkage whatsoever.

In market structure analysis, observations imply that market power, not the efficient structure, hold a country’s banking industry and dependable variables such as the bank concentration and specific traits. It dismisses the major role of market power explaining that concentration and institutional have great impacts on bank net interest margins since they control a number of macroeconomic factors, financial and bank specific traits…

This analysis defines the “efficiency” market to be linked to the larger institutions, rather than the small markets levels, which proves to be the tradition in banking literature as mentioned by various researchers in this essay. The theory that stipulates that higher interest margins equals higher profits does not provide any evidence to support this claim. Since research shows that higher inflation rates correlate positively with net interest margins, noting that concentration measures remain relatively unchanged at the higher or lower interest margins, policy makers should therefore consider eliminating this variable to eliminate the cross-differences that exist between national and local markets.

Evidence that focuses on the impact of bank regulations suggests that concentration changes on small institutions levels, but increases at state levels and since bank characteristics depend on individual countries variation in financial intermediation, larger banking institutions such as the U.S are placed at greater advantage due to their high concentration levels. One major obstacle that limits small institutions is the numerous regulatory requirements that subjected them to large overhead costs. The research therefore argues that these countries should practice deregulatory strategy to increase concentration at local levels, since the literature here defines larger institutions as efficient markets

Since a number of variable factors contribute to market concentration, policy makers should monitor these factors that influence concentration within banking industry at state level and as well as local levels to eliminate the accumulation of monopoly power which will subsequently improve banking profits of smaller institutions.

List of References

Barth, J., & Levine, R. 2001, The Regulating and Supervision of Banks around the World: A New Database, In integrating Emerging Market Countries into the Global Financial System, Brooking-Wharton papers on Financial Services, Brooking Institution Press, Washington, DC.

Bank for International Settlements. 2001, The Banking Industry in the Emerging Market Economies: Competition, Consolidation, and Systematic Stability, BIS Papers, vol.4.

Barth, J., & Levine, R. 2003, Bank Regulation and Supervision: What works Best?, Journal of Financial Intermediation, forthcoming.

Demsetz, H. 1973, Industry structure, Market Rivalry, and Public Policy, Journal of Law and Economics, vol. 16, pp.1-9.

Engerman, S., & Sokoloff, K. L. 1997, Factor Endowments, Institutions, and Differential Paths of Growth among New World Economies: A view from Economic Historians of the United States, Stanford University Press, Stanford.

International Monetary fund. 2001, Financial Sector Consolidation in Emerging Markets, chap V. International Capital Market Report.

Jayaratne, J., & Strahan, P.E.1996, The Finance-Growth Nexus; Evidence from Bank Branch Deregulations, Quarterly Journal of Economics, vol. 111, pp. 639-670.

Jayaratne, J., & Strahan, P.E.1999, Entry Restrictions, Industry Evolution and Dynamic Efficiency: Evidence from Commercial Banking, Journal of Law and Economics, vol.40, pp. 239-274

Levine, R., & Laeven.2003, Regulations, Market Structure, Institutions, and the Cost of Finance Intermediation, National Bureau of Economic Research working paper. Pp.1-30.

Peltzman, S. 1977, The Gains and Loses from Industrial Concentration, Journal of Law and Economics, vol. 20, pp. 229-263.

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