Market entry, privatisation and bank Market entry, privatisation and bank performance in transitionperformance in transition

Steven Fries, Damien Neven, Steven Fries, Damien Neven, Paul Seabright and Anita TaciPaul Seabright and Anita Taci

EIASM Workshop on Financial DevelopmentEIASM Workshop on Financial DevelopmentPrague, 26 May 2006Prague, 26 May 2006

IntroductionIntroduction

Many policies used to change socialist banking systems into market-oriented ones, including

– Restructuring and privatisation of state banks

– Entry of new private banks, including foreign

Gauge impact of reforms on banking development by examining revenue and costs

– Foreign banks are low marginal cost entrants

– Privatised banks attract greater demand

– Differences among private banks diminish over time

– State banks under perform on both demand and costs

Approach of the paperApproach of the paper

Develop unique model of monopolistic competition in bank lending and deposit taking to analyse revenues– Look for effects of market entry and ownership on

deposit and loan margins Use standard trans-log specification for costs

– Estimate marginal costs by ownership type Compare margins and marginal costs for mark-ups

– Indicates ability to attract demand for loans and deposits Allow parameters of revenues and costs to vary

over time

Existing literatureExisting literature

Banking market structures in transition economies (TEs)

– Gelos and Roldós (2002), Yildirim and Philippatos (2002a) and Drakos and Konstantinou (2003)

– Evidence of monopolistically competitive markets

– Increasing competition over time Cost / profit efficiency of banks in TEs

– Grigorian and Manole (2002), Yildirim and Philippatos (2002b), Bonin, Hasan and Wachtel (2005) and Fries and Taci (2005)

– Greater efficiency of foreign banks

Existing literature (cont’d)Existing literature (cont’d)

Determinants of bank net interest margins in TEs

– Drakos (2003)

– State-owned banks have relatively low margins

Theoretical models of imperfect competition and institutional development in TEs

– Hainz (2003a, 2003b)

– Studies show that the market power of banks decreases as the quality of institutions improves

The starting point: bank profit functionThe starting point: bank profit function

Accounting identity

LoanLoanmarginmargin

DepositDepositmarginmargin

Non-loan assetsNon-loan assetsmarginmargin

Operating costsOperating costs

Interbank rateInterbank rate

ii r riillLLii - r - rii

ddDDii + r + riinnNNii - R(L - R(Lii + N + Nii - E - Eii - D - Dii) - C(D) - C(Dii,N,Nii,L,Lii,W,Wii))

ii (r (riill - R)L - R)Lii + (R - r + (R - rii

dd)D)Dii + (r + (riinn - R)N - R)Nii + Re + Reii - C(D - C(Dii,N,Nii,L,Lii,W,Wii))

Equilibrium determination of loan and deposit margins in monopolistically competitive markets

The empirical specificationThe empirical specification

Revenue function is therefore

Margins are a function of number of competitors, market shares and bank ownership

REVREVijtijt = M = Mijtijtll((••)L)Liktikt + M + Mijtijt

dd((••)D)Diktikt + + ρρNNijtijt + + σσEEijtijt + + ijtijt

REVREVijtijt = M = Mijtijtl+dl+d((••)(L)(Liktikt + D + Diktikt) + ) + ρρNNijtijt + + σσEEijtijt + + εεijtijt

Combine loans and deposits into a single scale variable because of their co-linearity

Empirical specification (cont’d)Empirical specification (cont’d)

Trans-log specification for costs

Higher order terms omitted because they were insignificant in preliminary estimations

Allow estimated constants to vary by bank ownership and over time Identifies differences in average costs across

bank types

lnlnCCijtijt = = ααoo + + ΣΣsstt ββss lnlnQQs,ijts,ijt + + ΣΣmm

nn X Xmm lnlnWWm,ijtm,ijt

DatasetDataset

Bankscope database for accounting data– 477 banks in 15 transition economies

– Sample period covers 1995 – 2004

– Unbalanced panel, 115 banks for entire sample period

Unique coverage of bank ownership– Time varying measures of ownership based on

EBRD staff research

– Newly established, privatised and state-owned

– Domestic and foreign

Basic data on bank revenuesBasic data on bank revenues

Revenues to total assets in per cent

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

New domestic New foreign Privatiseddomestic

Privatisedforeign

State owned

1995-98 1999-2001 2002-04

Basic data on bank costsBasic data on bank costs

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

New domestic New foreign Privatiseddomestic

Privatisedforeign

State owned

1995-98 1999-2001 2002-04

Operating costs to total assets in per cent

Results – Revenue equation Results – Revenue equation (revenue adjusted for inflation)(revenue adjusted for inflation)

Explanatory variables

Interacted with loans plus deposits

Loans

Newly established, domestic

Newly established, foreign

Privatised, domestic

Privatised, foreign

Number of banks per million of population

Share of loan and deposit market

IAS dummy variable

0.0320***

Deposits

1995 - 1998 1999 - 2001

Non-Loan financial assets

Equity

0.0007

0.0194

0.0609***

2002 - 2004

-0.0350***

0.0475***

-0.0096

-0.0184***

0.0199***

0.0052**

-0.0005

0.0015***

-0.0101

0.0125

0.2408***

0.0095***

-0.0094***

0.0275***

0.0051**

-0.0012**

0.0289***

-0.0289***

0.0105***

0.0081***

0.0282***

0.0038***

0.0002

0.0063*

-0.0089**

0.0391***

0.2749***

0.0194***

0.2906***

Results – Cost equationResults – Cost equation

Ln (loans + deposits)

Ln (loans + deposits ^ 2

Ln (operating costs / total assets)

Ln (operating costs / total assets) ^ 2

Ln (non-loan financial assets)

Equity to total assets ratio

Newly established, domestic

Newly established, foreign

Privatised, domestic

Privatised, foreign

1995 - 1998 1999 - 2001 2002 - 2004

0.7995***

0.0021

0.3681***

0.1715***

0.0331

-0.0019

-0.2649***

-0.3767***

-0.2767***

-0.0209

0.6101***

0.0360***

1.3556***

0.2036***

0.1075***

-0.1170

-0.0833*

-0.0051

-0.0340

0.0263

0.6332***

0.0410**

0.9657***

0.0370*

0.0529***

0.3072**

-0.0298

0.0303

0.0083

-0.0377

Marginal costs and mark-upsMarginal costs and mark-ups

Foreign bank marginal costs below that of state bank

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

New domestic New foreign Privatised, domestic Privatised, foreign

1995-98 1999-2001 2002-04

Marginal costs and mark-upsMarginal costs and mark-ups

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

New domestic New foreign Privatised, domestic Privatised

1995-98 1999-2001 2002-04

Mark-ups above state bank benchmark

Foreign banks are low marginal cost entrants Privatised banks attract greater demand

– Evidence that newly established banks attract more demand with a lag

New domestic banks had weaker performance than other private banks– While differences diminish over time, this casts doubts on

liberal entry policies for domestic banks State banks are the weakest performers throughout Policy implications

– Openness to foreign entry (costs) and privatisation of state banks to both domestic and foreign owners (demand)

ConclusionConclusion