Financial Sector Assessment

Competition, Concentration, and Efficiency

Competition in the financial system can be defined as the extent to which financial markets are contestable and the extent to which consumers can choose a wide range of financial services from a variety of providers. Competition is often a desirable feature because it normally leads to increased institutional efficiency, lower costs for clients, and improvements in the quality and range of financial services provided. There are numer­ous measures of competition, including the total number of financial institutions, changes in market share, ease of entry, price of services, and so forth. In addition, the degree of diversity of the financial system could be an indicator of competition or the lack thereof because the emergence of vibrant non-bank intermediaries and capital markets often have been a source of effective competition for banking systems in many countries. All things remaining equal, an increase in the number of financial institutions or an expansion in available financial market instruments will increase competition by expanding the avail­able sources of financial services that consumers can access. Ease of entry into the system could be judged by looking at the regulatory and policy requirements for licensing, for example, the required minimum paid-up capital.

In many cases, the ownership structure of the financial system can be indicative of competition or lack thereof. For instance, banks of different ownership often have dif­ferent mandates and clientele, leading to substantial market segmentation. Also, systems dominated by state-owned financial institutions tend to be less competitive than those in which privately owned institutions are very active because state ownership often dampens commercial orientation. In some cases, the shares of domestic - and foreign-owned finan­cial institutions in various financial sub-sectors could be relevant in assessing competition and incentives for financial innovations.

Measures of concentration often have been used as indicators of competition. Concentration is defined as the degree to which the financial sector is controlled by the biggest institutions in the market (as defined by market shares). For example, the three - bank concentration ratio measures the market share of the top three banks in the system, defined in terms of assets, deposits, or branches. Deciding what is concentrated and what is not depends a lot on judgment, and benchmarking becomes critical.5 A more sophisti­cated measure of concentration is the Herfindahl Index (HI), which is the sum of squares of the market shares of all firms in a sector. Higher values of the index indicate greater market concentration. When applied to the financial sector, this index uses information about the market share of each bank to obtain a single summary measure.6 The concept of concentration also could be applied to financial markets, especially by examining the share of different market instruments in the total outstanding value of financial market instruments. For example, the relative shares of money and capital market instruments in total financial assets could give an indication of the extent to which financial markets are positioned between short-term and long-term intermediation. Information on holdings of the instruments by types of investors and by number of issuers of different instruments also helps assess market competition.

The sustainable development of a financial system and the degree to which it provides support to real sector activities depend to a large extent on the efficiency with which intermediation occurs. Efficiency refers to the ability of the financial sector to provide high-quality products and services at the lowest cost. Competition and efficiency of the financial system are related to a large extent because more competitive systems invari­ably turn out to be more efficient (all other things being equal). Quantitative measures of efficiency that could be evaluated include (a) total costs of financial intermediation as percentage of total assets and (b) interest rate spreads (lending minus deposit rates). Components of intermediation costs include operating costs (staff expenses and other overhead), taxes, loan-loss provisions, net profits, and so forth. Those costs can be derived from the aggregated balance sheet and income statements for financial institu­tions. However, interest rate spreads sometimes remain high despite efficiency gains because of the need to build loan-loss provisions or charge a risk premium on lending to high-risk borrowers.

For money and capital markets, efficiency implies that current security prices fully reflect all available information. Hence, in an efficient financial market, day-to-day movements of market prices tend to be random, and information on past prices would not help predict future prices. The bid-ask spread (i. e., the difference between prices at which participants are willing to buy and sell financial instruments) is often used as a proxy for measuring the efficiency of markets, with more efficient markets exhibiting narrower

bid-ask spreads. Because bid-ask spread also reflects market liquidity, as discussed below, additional analysis of the extent of competition in the market and of volatility of price movements would be needed to assess efficiency. In addition, measures of price volatil­ity are sometimes used to substitute for market efficiency, although short-run changes in volatility may reflect shifts in the amount of liquidity in that market.

Two important dimensions of market liquidity should be considered: market depth and market tightness. Market depth refers to the ability of the market to absorb large trade volumes without significant impact on market prices.7 This dimension is usually measured by the ratio of value traded to market capitalization (turnover ratio), with higher ratios indicating more liquid markets. Another dimension of liquidity is market tightness—abil­ity to match supply and demand at low cost that is measured by the average bid-ask spread. More liquid markets usually have narrower bid-ask spreads. Further discussion of these indicators can be found in section 2.2.4.

Table 2.2 summarizes the indicators of financial system performance that have been discussed in this section.