Bank Efficiency and Market Structure: What Determines Banking Spreads in Armenia?

Era Dabla Norris and Holger Floerkemeier

Motivation

Banking spreads as indicators of efficiency of financial intermediation- Transition-countries financial systems mainly bank-

based - High cost of financial intermediation impedes

financial deepening Case study: Armenia

- Despite progress in banking sector reform:- Low financial intermediation- High banking spreads

Comparatively advanced banking sector reforms,

1994 2000 2007 1994 2000 2007

Estonia 3.00 3.67 4.00 1.67 3.00 3.67Latvia 3.00 3.00 4.00 2.00 2.33 3.00Lithuania 2.00 3.00 3.67 2.00 3.00 3.33Russia 2.00 1.67 2.33 1.67 1.67 3.00Armenia 1.00 2.33 2.67 1.00 2.00 2.00Georgia 1.00 2.33 2.67 1.00 1.67 1.67Kazakhstan 1.00 2.33 3.00 1.67 2.33 2.67Ukraine 1.00 2.00 2.67 1.67 2.00 2.67Azerbaijan 1.00 2.00 2.33 1.00 1.67 1.67Kyrgyz Republic 1.00 2.00 2.33 1.00 2.00 2.00Tajikistan 1.00 1.00 2.33 1.00 1.00 1.00

Source: EBRD

Banking reform and interestrate liberalization

Securities markets and non-bank financial institutions

... but low financial development,

Financial Deepening, 2007

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

0.0 10.0 20.0 30.0 40.0 50.0 60.0

Broad Money/GDP

Pri

vate

Cre

dit/

GD

P

ARM'06ARM'07

GEO

KAZ UKR

LAT

RUS

... and persistently high banking spreads.

Domestic Currency Lending-Deposit Spreads(in percent)

0

5

10

15

20

25

30

Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07

ArmeniaGeorgiaAzerbaijanRussiaWest. CIS 1/Baltics

Source: IFS

1/ Western CIS includes Belarus, Moldova, Ukraine.

What we do

Examine role of bank characteristics, market structure, and macroeconomic variables in explaining intermediation efficiency in Armenia- Is there effect of differences in loan portfolios of banks?

- Do variations in market shares across market segments account for differences in spreads across banks?

- Has foreign entry played a role?

- Is there a spill-over effect of foreign banks on domestic banks?

- Does the origin of the foreign bank matter?

Armenian Banking System: Stylized Facts Substantial consolidation in past decade gradual tightening of prudential regulations and a number of bank failures

By 2007: 21 commercial banks; all privately owned since 2001

Foreign ownership has increased over time (14 banks; over 60 percent of total assets) - Only one international first-tier bank; others banks from CIS countries/ Armenian Diaspora

Small banking system (low asset/GDP ratio) but well capitalized, liquid, and profitable, with satisfactory level of asset quality.

Low overall concentration but segmented markets

Dataset

Panel of 20 banks 2002Q4 – 2006Q3 (16 quarters) Bank balance sheet and income data

Data sources: - Central Bank of Armenia- ARKA news agency

Methodology (1)

Ii,t = + Bi,t + Ct + Mt + i,t

Alternative spread variables (I) Bank characteristics (B), market structure (C),

and macroeconomic variables (M) as regressors

• OLS and Fixed effects regression• Time dummies• Robust clustered standard errors

Methodology – Dependent Variables Ex post interest spread

Difference between interest income divided by average loans and interest expenses divided by average deposits

Net interest marginDifference between total interest income and expenses over average assets

Ex ante spread (incomplete data)Difference between the weighted average lending rate and the weighted average deposit rate

Methodology – Independent Variables Bank characteristics

Overhead (+)Non-interest income (-)Bank size (-)Market share (+)Capital adequacy (+/-)ROA (+/-)Liquidity (+/-)Foreign bank dummy (-)Credit portfolio shares (+/-)

Methodology – Independent Variables Market structure

Concentration [HHI and CR] (+)Foreign participation (-)Market shares in loan segments (+)

Macroeconomic variablesExchange rate changes (+)Real GDP growth (-)Inflation (+)Money market rate (+)

Results – Bank Characteristics OLS FE FE OLS FE FE

Overhead 0.079 0.000 -0.009 0.058 0.008 0.008(0.037)** (0.030) (0.025) (0.022)** (0.014) (0.014)

Non-interest income -0.199 -0.010 0.058 -0.236 -0.068 -0.079(0.148) (0.097) (0.093) (0.084)** (0.056) (0.057)

Bank size -1.657 -2.444 -1.909 0.365 -0.042 -0.201(0.853)* (0.715)*** (0.676)** (0.333) (0.395) (0.427)

Market share 0.070 0.100 0.058 -0.025 -0.078 -0.070(0.031)** (0.042)** (0.040) (0.011)** (0.017)*** (0.016)***

Capital adequacy -0.011 -0.007 -0.005 -0.004 -0.003 -0.003(0.003)*** (0.005) (0.004) (0.001)*** (0.001)* (0.001)**

ROA 0.047 0.025 0.028 0.064 0.025 0.024(0.019)** (0.026) (0.026) (0.021)*** (0.012)** (0.012)*

Liquidity 0.000 -0.003 -0.003 0.001 -0.0005 -0.0004(0.001) (0.001)*** (0.001)*** (0.000)*** (0.000)** (0.000)**

Foreign bank -0.163 0.335 0.356 -0.364 -0.011 -0.005(0.306) (0.293) (0.276) (0.163)** (0.226) (0.280)

Agriculture 0.043 -0.004(0.006)*** (0.003)

Industry 0.007 -0.005(0.012) (0.004)

Consumer 0.014 -0.003(0.005)** (0.006)

Observations 303 303 303 303 303 303R-squared 0.284 0.605 0.648 0.481 0.777 0.781

Ex post Interest Spread Net Interest Margin

Results – Bank Characteristics OLS FE FE OLS FE FE

Overhead 0.079 0.000 -0.009 0.058 0.008 0.008(0.037)** (0.030) (0.025) (0.022)** (0.014) (0.014)

Non-interest income -0.199 -0.010 0.058 -0.236 -0.068 -0.079(0.148) (0.097) (0.093) (0.084)** (0.056) (0.057)

Bank size -1.657 -2.444 -1.909 0.365 -0.042 -0.201(0.853)* (0.715)*** (0.676)** (0.333) (0.395) (0.427)

Market share 0.070 0.100 0.058 -0.025 -0.078 -0.070(0.031)** (0.042)** (0.040) (0.011)** (0.017)*** (0.016)***

Capital adequacy -0.011 -0.007 -0.005 -0.004 -0.003 -0.003(0.003)*** (0.005) (0.004) (0.001)*** (0.001)* (0.001)**

ROA 0.047 0.025 0.028 0.064 0.025 0.024(0.019)** (0.026) (0.026) (0.021)*** (0.012)** (0.012)*

Liquidity 0.000 -0.003 -0.003 0.001 -0.0005 -0.0004(0.001) (0.001)*** (0.001)*** (0.000)*** (0.000)** (0.000)**

Foreign bank -0.163 0.335 0.356 -0.364 -0.011 -0.005(0.306) (0.293) (0.276) (0.163)** (0.226) (0.280)

Agriculture 0.043 -0.004(0.006)*** (0.003)

Industry 0.007 -0.005(0.012) (0.004)

Consumer 0.014 -0.003(0.005)** (0.006)

Observations 303 303 303 303 303 303R-squared 0.284 0.605 0.648 0.481 0.777 0.781

Ex post Interest Spread Net Interest Margin

Results – Bank Characteristics OLS FE FE OLS FE FE

Overhead 0.079 0.000 -0.009 0.058 0.008 0.008(0.037)** (0.030) (0.025) (0.022)** (0.014) (0.014)

Non-interest income -0.199 -0.010 0.058 -0.236 -0.068 -0.079(0.148) (0.097) (0.093) (0.084)** (0.056) (0.057)

Bank size -1.657 -2.444 -1.909 0.365 -0.042 -0.201(0.853)* (0.715)*** (0.676)** (0.333) (0.395) (0.427)

Market share 0.070 0.100 0.058 -0.025 -0.078 -0.070(0.031)** (0.042)** (0.040) (0.011)** (0.017)*** (0.016)***

Capital adequacy -0.011 -0.007 -0.005 -0.004 -0.003 -0.003(0.003)*** (0.005) (0.004) (0.001)*** (0.001)* (0.001)**

ROA 0.047 0.025 0.028 0.064 0.025 0.024(0.019)** (0.026) (0.026) (0.021)*** (0.012)** (0.012)*

Liquidity 0.000 -0.003 -0.003 0.001 -0.0005 -0.0004(0.001) (0.001)*** (0.001)*** (0.000)*** (0.000)** (0.000)**

Foreign bank -0.163 0.335 0.356 -0.364 -0.011 -0.005(0.306) (0.293) (0.276) (0.163)** (0.226) (0.280)

Agriculture 0.043 -0.004(0.006)*** (0.003)

Industry 0.007 -0.005(0.012) (0.004)

Consumer 0.014 -0.003(0.005)** (0.006)

Observations 303 303 303 303 303 303R-squared 0.284 0.605 0.648 0.481 0.777 0.781

Ex post Interest Spread Net Interest Margin

Results – Bank Characteristics Significant role of bank-specific fixed effects Ex-post interest spreads depend on

- Bank size (economies of scale)- Deposit market share (market power)- Liquidity

- Loan portfolio Net interest margins depend on

- Deposit market share (but negative sign)- Capital adequacy- ROA- Liquidity

Foreign banks not associated with lower spreads/margins

Results - Market Structure: Foreign Ownership (1) (2) (3) (1) (2) (3)

Bank size -2.452 -2.562 -2.615 -0.154 -0.170 -0.340(0.711)*** (0.676)*** (0.691)*** (0.377) (0.384) (0.398)

Market share deposits 0.099 0.078 0.092 -0.080 -0.077 -0.072(0.041)** (0.031)** (0.038)** (0.016)*** (0.017)*** (0.017)***

Capital adequacy -0.007 -0.010 -0.009 -0.003 -0.003 -0.003(0.005)* (0.004)** (0.004)** (0.002)* (0.002) (0.002)

ROA 0.025 0.026 0.025 0.022 0.022 0.021(0.027) (0.025) (0.026) (0.011)* (0.011)* (0.011)*

Liquidity -0.003 -0.003 -0.003 -0.001 -0.001 -0.0005(0.001)*** (0.001)*** (0.001)*** (0.000)*** (0.000)*** (0.000)**

Foreign bank -0.348 -0.027(0.283) (0.249)

Foreign participation loans 0.039 0.041 -0.009 -0.010(0.025) (0.026) (0.003)*** (0.003)**

Foreign participation deposits 0.033 -0.009(0.023) (0.004)**

Foreign Participation* Western Bank -0.061 -0.087 0.006 0.006(0.009)*** (0.015)*** (0.004) (0.005)

Foreign Participation* Other Foreign Bank 0.011 0.007 0.000 -0.001(0.006)* (0.003)** (0.003) (0.003)

Fixed Effects YES YES YES YES YES YESObservations 303 303 303 303 303 303R-squared 0.608 0.632 0.625 0.756 0.775 0.749

Ex post Interest Spread Net Interest Margin

Results - Market Structure: Concentration

Bank size -1.742 -1.313 0.080 0.069

(0.673)** (0.673)** (0.368) (0.366)

Market share deposits 0.072 0.043 -0.083 -0.084

(0.044) (0.052) (0.017)*** (0.017)***

Capital adequacy -0.007 -0.005 -0.003 -0.003

(0.005) (0.005) (0.002)* (0.002)*

ROA 0.027 0.026 0.025 0.025

(0.027) (0.025) (0.012)** (0.012)**

Liquidity -0.003 -0.003 -0.0004 -0.0003

(0.001)*** (0.001)*** (0.000)** (0.000)**

Foreign bank 0.332 0.313 -0.011 -0.013

(0.285) (0.262) (0.227) (0.232)

HHI (loans) 0.003 0.000

(0.002)** (0.001)

HHI (deposits) 0.001 0.0004

(0.000)** (0.000)*

Fixed Effects YES YES YES YES

Observations 303 303 303 303

R-squared 0.593 0.567 0.786 0.777

Net Interest MarginEx post Interest Spread

Results - Market Share and Macroeconomic Variables(1) (2) (1) (2)

Bank size -1.597 -1.391 -0.219 -0.209(0.688)** (0.539)** (0.448) (0.375)

Market share deposits 0.074 0.052 -0.094 -0.076(0.032)** (0.045) (0.022)*** (0.015)***

Capital adequacy -0.008 -0.004 -0.003 -0.003(0.004)* (0.005) (0.002)* (0.002)**

ROA 0.033 0.026 0.022 0.024(0.029) (0.025) (0.010)** (0.012)*

Liquidity -0.003 -0.003 -0.0004 0.000(0.001)** (0.001)*** (0.000)** (0.000)

Foreign bank 0.523 0.299 -0.009 -0.055(0.340) (0.314) (0.169) (0.207)

Market share (industry) -0.064 0.019(0.027)** (0.006)***

Market share (agriculture) -0.009 -0.002(0.034) (0.018)

Market share (consumer loans) -0.010 0.032(0.028) (0.018)*

Exchange rate -0.004 0.017(0.022) (0.007)**

RGDP 0.000 0.015(0.011) (0.007)**

Inflation 0.018 0.021(0.029) (0.015)

Money market rate 0.0004 -0.011(0.000)** (0.013)

Fixed effects YES YES YES YESR-squared 0.602 0.557 0.786 0.760

Ex post Interest Spread Net Interest Margin

Results - Market Structure And Macroeconomic Variables Foreign ownership has no robust impact

- foreign bank dummy mostly insignificant- foreign bank presence in loan/deposit market lowers

margins evidence of spill-over effect

- origin seems to matter for lowering spreads Concentration raises spreads and margins

- HHI: impact significant and robust- Market share in industry loans lowers spread- Market share in industry and consumer loans raises margins

Macroeconomic variables not very important

Conclusions

Economies of scale Market power Market segmentation

- relationship banking- information sharing- market transparency

Foreign ownership- no direct effect

- but possibly spillover effects

- origin of foreign bank matters