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A framework for analyzing competition in the banking sector : an application to the case of Jordan

TL;DR: In this paper, a multi-pronged approach is proposed to analyze competition in the banking sector using Jordan as an example, where the authors examine the extent to which the market is contestable (that is, has low barriers to bank entry and exit), an evaluation of the behavior of bank spreads, and an assessment of non-structural and direct measures of bank competition.
Abstract: This paper proposes a framework to analyze competition in the banking sector using Jordan as an example. In particular, the paper pursues a multi-pronged approach to analyze competition including (i) an examination of the extent to which the market is contestable (that is, has low barriers to bank entry and exit), (b) an evaluation of the behavior of bank spreads, and (iii) an assessment of non-structural and direct measures of bank competition such as the H-statistic and the Lerner Index. This approach provides a more comprehensive framework to examine competition in the banking sector, compared with the commonly used alternative of looking only at bank concentration figures. In the case of Jordan, the analysis indicates that although concentration has declined, competition in the country is low and has decreased over time.

Summary (2 min read)

1. Introduction

  • The share of assets held by the three largest banks is close to 70 percent when the authors take into account the global assets of Jordanian banks.
  • Though concentration levels have come down recently, they still exceed that of many countries in the region (Table 1).
  • The framework is applied to Jordan but can be used to analyze bank competition in any country.
  • First, the paper examines banking sector contestability by looking into the licensing procedures and practices, the capital requirements, and the regulations affecting bank activities and transparency.

2. Assessing Banking Sector Contestability

  • A market is contestable when barriers to bank entry and exit are low.
  • Regulations that enable bank entry and operations and foster bank disclosure can bring greater contestability to the banking sector and promote competition.
  • The capital required to begin banking operations is approximately 56 million U.S. dollars for domestic banks and half of that amount for foreign banks.
  • Jordan does not seem very different from the comparator countries on regulations concerning bank transparency; however, in practice, transparency could be enhanced by promoting greater disclosure of bank operations and prices.
  • Auditors are required to report to supervisors any information discovered in an audit that could jeopardize the health of a bank.

3. Analyzing Bank Spreads

  • The banking literature has often used bank spreads (the difference between contractual lending and deposit rates) and ex-post interest margins (measured as interest income minus expenses relative to bank assets) as indicators of banking efficiency and competition.
  • Higher spreads and margins are often interpreted to signal greater inefficiencies and lack of competition in the banking sector.
  • Ex-ante average interest rate spreads in Jordan have declined in the last decade (from 4.8 percent to 3.2 percent), but they exceed those for neighboring countries such as Israel and Lebanon .
  • Furthermore, distinguishing between the spreads on the prime rate charged to the best bank borrowers (large corporations) and the average rates on all lending instruments indicates that the spreads charged to non-prime borrowers can be higher than those reported in Figure 2 (see Table 4).
  • Though no information is available from the Central bank of Jordan on the spreads on corporate vis-à-vis SME and retail lending, anecdotal evidence suggests that spreads on SMEs and retail clients range between 3 and 4 percent.

4. Computing a Direct Measure of Competition in the Banking Sector

  • Looking only at spreads can be problematic since spreads can reflect countries’ macroperformance, the extent of taxation of financial intermediation, the quality of the contractual and judicial environment, and bank-specific factors such as scale and risk preferences.
  • The recent banking literature analyzes more direct measures of competition based on models of industrial organization that emphasize market contestability.
  • Note that the authors are able to accept the null of long-run equilibrium, indicating that the H-statistics are valid, irrespective of the sample considered.
  • These variables come from the World Development Indicators.

5. Measuring Market Power

  • An alternative way to examine competition in banking is to compute direct measures of market power, since greater market power implies less competition.
  • The Lerner Index is computed using the formula (P-MC)/P, where P is the price of banking outputs and MC is the marginal costs.
  • As in most papers, the estimation is done under the restrictions of symmetry and degree one homogeneity in the price of inputs.
  • This decline in competition is consistent with what the authors find using the H-statistic.

6. Conclusions

  • The banking sector in Jordan is concentrated.
  • This paper proposes a framework for analyzing competition which 8 Maudos and Solis find that the Lerner Index for Mexico varied between 0.05 and 0.15 between 1993 and 2005.
  • Aside from being concentrated, the Jordanian banking sector exhibits other characteristics that suggest that the levels of competition and contestability can be improved.
  • Capital requirements are high and entry has in practice been restricted by the Central Bank.
  • The system also lacks a fully-developed and tested exit framework that encourages competition.

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P R W P
5499
A Framework for Analyzing Competition
in the Banking Sector
An Application to the Case of Jordan
Asli Demirguc-Kunt
María Soledad Martínez Pería
e World Bank
Development Research Group
Finance and Private Sector Development Team
December 2010
WPS5499
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Produced by the Research Support Team
Abstract
e Policy Research Working Paper Series disseminates the ndings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the ndings out quickly, even if the presentations are less than fully polished. e papers carry the
names of the authors and should be cited accordingly. e ndings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. ey do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its aliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
P R W P5499
is paper proposes a framework to analyze competition
in the banking sector using Jordan as an example. In
particular, the paper pursues a multi-pronged approach to
analyze competition including (i) an examination of the
extent to which the market is contestable (that is, has low
barriers to bank entry and exit), (b) an evaluation of the
behavior of bank spreads, and (iii) an assessment of non-
structural and direct measures of bank competition such
is paper is a product of the Finance and Private Sector Development Team, Development Research Group. It is part of
a larger eort by the World Bank to provide open access to its research and make a contribution to development policy
discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org.
e authors may be contacted at Ademirguckunt@worldbank.org @worldbank.org, Mmartinezperia@worldbank.org.
as the H-statistic and the Lerner Index. is approach
provides a more comprehensive framework to examine
competition in the banking sector, compared with the
commonly used alternative of looking only at bank
concentration gures. In the case of Jordan, the analysis
indicates that although concentration has declined,
competition in the country is low and has decreased over
time.

A Framework for Analyzing Competition in the Banking Sector:
An Application to the Case of Jordan
Asli Demirguc-Kunt and María Soledad Martínez Pería
Keywords: bank competition, market structure
JEL: G21, L11
Asli Demirguc-Kunt is Chief Economist in the Vice Presidency of Finance and Private Sector Development and a
Senior Research Manager in the Finance and Private Sector Development Research Group of the Development
Economics Vicepresidency. Maria Soledad Martínez Pería is a Senior Economist in the aforementioned group. We
are grateful to Zsofia Arvai, Mario Guadamillas, Barry Johnston, Susan Marcus, Roberto Rocha, David Scott, and
participants in the FSAP Unit Brown Bag Lunch Seminar Series for many useful comments and suggestions. We
thank Subika Farazi for excellent research assistance. The views and opinions in this paper are those of the authors
and do not reflect those of The World Bank and/or its Executive Directors. Corresponding author
: María Soledad
Martínez Pería, The World Bank, 1818 H St., N.W., MSN 3-300, Washington, D.C. 20433.
mmartinezperia@worldbank.org
.

- 2 -
1. Introduction
The Jordanian banking sector is concentrated. The share of assets held by the three largest banks
is close to 70 percent when we take into account the global assets of Jordanian banks.
1
Though
concentration levels have come down recently, they still exceed that of many countries in the
region (Table 1). However, concentration is not equivalent to competition (see Jackson, 1992 and
Cetorelli, 1999), since contestable sectors where barriers to entry and exit are low can remain
competitive. As a result an analysis of bank competition in Jordan requires a more
comprehensive framework.
This paper proposes a multi-pronged approach to examine the extent of competition in
the banking sector. The framework is applied to Jordan but can be used to analyze bank
competition in any country.
2
First, the paper examines banking sector contestability by looking
into the licensing procedures and practices, the capital requirements, and the regulations
affecting bank activities and transparency. As part of evaluating contestability, the paper also
examines the experience with bank exit. Second, the paper analyzes the behavior of bank spreads
– the difference between lending and deposit rates, a measure of the cost of financial
intermediation and a frequently used indicator of efficiency and bank competition. Third, the
paper computes the Panzar and Rosse (1987) H-statistic, a non-structural and more direct
measure of competition, which captures the elasticity of interest revenues with respect to input
prices. As a robustness check, the paper also presents estimates of the degree of market power in
the Jordanian banking sector by reporting the Lerner Index, defined as the difference between
output prices and marginal costs relative to prices.
The analysis shows that bank competition in Jordan is low and has decreased in recent
years. The current concentrated market structure and the lack of contestability in the Jordanian
banking sector appear to explain the low level of competition.
1
It is worthwhile to consider concentration based on global assets, because the global activity of some banks can
give them a comparative advantage and, hence, increase their market power at home as a result.
2
In fact, other studies have used this framework to analyze competition in Russia (Anzoategui, Martinez Peria, and
Melecky, 2010), in China (Demirguc-Kunt, Martinez Peria, and Merrouche, 2010) and to compare banking sector
competition in the Middle East and Northern Africa Region to that in other regions (Anzoategui, Martinez Peria, and
Rocha, 2010).

- 3 -
2. Assessing Banking Sector Contestability
A market is contestable when barriers to bank entry and exit are low. The threat of bank entry
and exit can exert pressure on incumbent banks and keep the sector competitive even if banking
sector concentration is high. By facilitating bank entry and operations and by promoting
transparency, the regulatory framework practices can have a significant impact on banking sector
contestability and competition. Regulations that enable bank entry and operations and foster
bank disclosure can bring greater contestability to the banking sector and promote competition.
Hence, an analysis of competition in the banking sector requires a close examination of the
regulations regarding bank entry and transparency in the banking sector. At the same time, it is
important to analyze how regulations are implemented in practice since even if de jure barriers to
entry and exit appear not to be very restrictive, regulators can limit entry and exit de facto.
Table 2 compares Jordan to a sample of selected countries along these dimensions. In
Jordan, the Central Bank grants commercial banking licenses. Only one license is required for a
bank to begin its operations. This license covers all permitted banking activities. The capital
required to begin banking operations is approximately 56 million U.S. dollars for domestic banks
and half of that amount for foreign banks. With the exception of Egypt, where banks require 86
million U.S. dollars as initial capital, the amounts required in Jordan are much higher than those
in neighboring countries as shown in Table 2. Furthermore, the initial capital requirements in
Jordan far exceed those in other countries with similar or higher levels of financial development,
where they average 5 to 10 million U.S. dollars.
To obtain a banking license, banks in Jordan need to present information on or submit the
following: (1) draft by-laws, (2) the intended organization chart, (3) financial projections for the
first three years, (4) financial information on the main potential shareholders, (5)
background/experience of future directors, (6) background/experience of future managers, (7)
sources of funds to be disbursed in the capitalization of the new bank, and (8) market
differentiation of the new bank. Most comparator countries have the same eight requirements,
with the exception of Israel where only three requirements have to be met (3, 5, and 6, as defined
above).

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References
More filters
Posted Content
TL;DR: Demirguc-Kunt and Huizinga as discussed by the authors used bank data for 80 countries for 1988-95 and found that differences in interest margins and bank profitability reflect various determinants: bank characteristics, macroeconomic conditions, existing financial structure and taxation, regulation, and other institutional factors.
Abstract: Differences in interest margins reflect differences in bank characteristics, macroeconomic conditions, existing financial structure and taxation, regulation, and other institutional factors. Using bank data for 80 countries for 1988-95, Demirguc-Kunt and Huizinga show that differences in interest margins and bank profitability reflect various determinants: Bank characteristics. Macroeconomic conditions. Explicit and implicit bank taxes. Regulation of deposit insurance. General financial structure. Several underlying legal and institutional indicators. Controlling for differences in bank activity, leverage, and the macroeconomic environment, they find (among other things) that: Banks in countries with a more competitive banking sector-where banking assets constitute a larger share of GDP-have smaller margins and are less profitable. The bank concentration ratio also affects bank profitability; larger banks tend to have higher margins. Well-capitalized banks have higher net interest margins and are more profitable. This is consistent with the fact that banks with higher capital ratios have a lower cost of funding because of lower prospective bankruptcy costs. Differences in a bank's activity mix affect spread and profitability. Banks with relatively high noninterest-earning assets are less profitable. Also, banks that rely largely on deposits for their funding are less profitable, as deposits require more branching and other expenses. Similarly, variations in overhead and other operating costs are reflected in variations in bank interest margins, as banks pass their operating costs (including the corporate tax burden) on to their depositors and lenders. In developing countries foreign banks have greater margins and profits than domestic banks. In industrial countries, the opposite is true. Macroeconomic factors also explain variation in interest margins. Inflation is associated with higher realized interest margins and greater profitability. Inflation brings higher costs-more transactions and generally more extensive branch networks-and also more income from bank float. Bank income increases more with inflation than bank costs do. There is evidence that the corporate tax burden is fully passed on to bank customers in poor and rich countries alike. Legal and institutional differences matter. Indicators of better contract enforcement, efficiency in the legal system, and lack of corruption are associated with lower realized interest margins and lower profitability. This paper - a product of the Development Research Group - is part of a larger effort in the group to study bank efficiency.

2,029 citations

Journal ArticleDOI
TL;DR: This paper showed that differences in interest margins and bank profitability reflect a variety of determinants: bank characteristics, macroeconomic conditions, explicit and implicit bank taxation, deposit insurance regulation, overall financial structure, and underlying legal and institutional indicators.
Abstract: Using bank-level data for 80 countries in the year's 1988-95, this article shows that differences in interest margins and bank profitability reflect a variety of determinants: bank characteristics, macroeconomic conditions, explicit and implicit bank taxation, deposit insurance regulation, overall financial structure, and underlying legal and institutional indicators. A larger ratio of bank assets to gross domestic product and a lower market concentration ratio lead to lower margins and profits, controlling for differences in bank activity, leverage, and the macroeconomic environment. Foreign banks have higher margins and profits than domestic banks in developing countries, while the opposite holds in industrial countries. Also, there is evidence that the corporate tax burden is fully passed onto bank customers, while higher reserve requirements are not, especially in developing countries.

1,426 citations

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TL;DR: In this article, the authors apply the Panzar and Rosse (1987) methodology to estimate the extent to which changes in input prices are reflected in revenues earned by specific banks in 50 countries' banking systems.
Abstract: Using bank-level data, the authors apply the Panzar and Rosse (1987) methodology to estimate the extent to which changes in input prices are reflected in revenues earned by specific banks in 50 countries' banking systems. They then relate this competitiveness measure to indicators of countries' banking system structures and regulatory regimes. The authors find systems with greater foreign bank entry and fewer entry and activity restrictions to be more competitive. They find no evidence that the competitiveness measure negatively relates to banking system concentration. Their findings confirm that contestability determines effective competition, especially by allowing (foreign) bank entry and reducing activity restrictions on banks.

1,416 citations


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TL;DR: In this article, the authors developed a general test for "monopoly" and derived testable restrictions on the firm's reduced-form revenue equation which must be satisfied by any profit-maximizing firm whose choices are not affected by either strategic interactions or the threat of entry.
Abstract: This paper develops a very general test for "monopoly." Using standard comparative statics analysis, the authors derive testable restrictions on the firm's reduced-form revenue equation which must be satisfied by any profit-maximizing firm whose choices are not affected by either strategic interactions or the threat of entry. For such an unfettered monopolist, the sum of the factor price elasticities of the reduced-form revenue equation must be nonpositive. The set of interesting alternative hypotheses is not empty. The authors develop simple models of oligopolistic, competitive, and monopolistically-competitive markets for which this test statistic may take on positive values. Copyright 1987 by Blackwell Publishing Ltd.

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"A framework for analyzing competiti..." refers background or methods in this paper

  • ...Based on the Panzar and Rosse (1982, 1987) methodology and following the empirical strategy pursued by Claessen and Laeven (2004), the H-statistic is calculated by estimating equation (1): Ln(Pit)= αi + β1 ln(W1,it) + β2 ln(W2,it) + β3 ln(W3,it) + γ ln(Z,it) + δD + εit (1) where i denotes banks and…...

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  • ...Third, the paper computes the Panzar and Rosse (1987) H-statistic, a non-structural and more direct measure of competition, which captures the elasticity of interest revenues with respect to input prices....

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  • ...A large number of studies have focused on measuring bank competition via the Panzar and Rosse (1982, 1987) Hstatistic, which captures the elasticity of bank interest revenues to input prices.5 Under perfect competition, an increase in input prices raises both marginal costs and total revenues by…...

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  • ...Panzar and Rosse (1987) show that when H is between 0 and 1 the system operates under monopolistic competition....

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Q1. What are the contributions mentioned in the paper "A framework for analyzing competition in the banking sector an application to the case of jordan" ?

In this paper, a multi-pronged approach is proposed to examine the extent of competition in Jordanian banking sector.