The financial liberalization in the 1990s appears to have aided the increase in competition among Philippine banks despite the increasing trend in concentration from bank mergers. The finding that Philippine banking industry is close to being perfectly competitive means that further consolidation in the banking sector would not severely undermine market competition.competition, banking sector, bank liberalization

Milo, Melanie S.

Pasadilla, Gloria

English

Research Papers in Economics

Policy Notes
December 2004    No. 2004-11
PHILIPPINE INSTITUTE
FOR DEVELOPMENT STUDIES
Surian sa mga Pag-aaral
Pangkaunlaran ng Pilipinas
Measuring bank
competitiveness:
Has financial liberalization
increased competition?
________________
* The author is Research Fellow, Philippine Institute for Devel-
opment Studies (PIDS).
PIDS Policy Notes are observations/analyses written by PIDS research-
ers on certain policy issues. The treatise is holistic in approach and
aims to provide useful inputs for decisionmaking.
This Notes is heavily based on the paper titled “Effect of liberalization
on banking competition” by G. Pasadilla and M. Milo. The views ex-
pressed are those of the author and do not necessarily reflect those of
PIDS or any of the study's sponsors.
Gloria O. Pasadilla*
T
ISSN 1656-5266
he 1990s ushered in major changes in the Phil-
ippine banking sector. Landmark legislations that
altered the regulations of the financial sector,
financial technology that advanced at a dizzying
pace, and bank consolidations and entry of new partici-
pants, especially foreign banks, all changed the face of
the industry.
These developments are expected to leave their mark on
cost efficiency, profitability, and competitive behavior
among industry participants. In particular, for instance,
what has been the impact of bank liberalization on com-
petition? This short Policy Notes makes a preliminary
assessment of this and draws policy implications for the
Bangko Sentral ng Pilipinas’ (BSP) policy of encouraging
more bank mergers and consolidations.
What some studies tell us
Why are we interested in increased bank competition?
Basic microeconomic theory indicates that competitive
behavior provides consumers better prices for the goods
that they buy and creates less economic cost to society.
Many empirical studies have established that an increase
in the number of market participants in the industry less-
ens market concentration, increases competition, and
helps improve efficiency, thus leading to lower cost and
lower market prices. In contrast, meanwhile, certain stud-
ies such as that of Berger and Hannan (1989), which is
based on an analysis of US bank data, show that non-
competitive behavior is positively associated with high
profits. Not that high profit is necessarily bad, especially
if it is a result of a high level of firm efficiency. What is
bad is if high profits are brought about only by monopo-
listic or oligopolistic structure because the huge economic
rents enjoyed by banks are almost likely made at the
expense of consumers.
Of course, it may be possible that the monopolistic or
oligopolistic firms are also more efficient. But studies
show that this is not always the case. In fact, heavily
concentrated markets are also found to exhibit low lev-December 2004 2
Policy Notes
els of efficiency. What is telling is that in rich countries
which have more developed financial systems, high lev-
els of bank concentration are positively correlated with
efficiency while in developing countries where there is a
low level of bank competition and high degree of concen-
tration, banks earn high profits not because they are ef-
ficient but because they have the entire market to only a
few of them.
In terms of government regulation, some studies also
assert that in countries where banking authorities have
tight entry regulation, banks enjoy high interest margins
but have high overhead costs and low levels of efficiency.
These findings affirm the need for a policy of freer mar-
ket entry and greater contestability in developing coun-
tries to overcome the monopoly power of domestic banks,
foster greater competition, lower costs, and improve bank
efficiency.
In this regard, what is the actual experience of allowing
foreign banks to enter the domestic banking market?
Using cross-country analysis, Claessens, Demirguc-Kunt
and Huizinga (2001) found that foreign bank entry has
helped reduce interest margins and made domestic bank-
ing systems more efficient. The results of similar stud-
ies demonstrate how foreign bank entry can improve the
functioning of national banking markets and improve na-
tional welfare, even as it reduces domestic bank profits.
A few studies using Philippine data have reached similar
conclusions that the entry of foreign banks lessened in-
dustry concentration and reduced interest spreads. The
impact on efficiency, however, has been fairly small due
to the limited scope of liberalization that the country has
undertaken so far.
Pinpointing the shift: alternative measurement
of competitiveness
But how do we know whether—and when—there has in-
deed been a shift from a monopolistic or oligopolistic
banking industry to a perfect competition in the Philip-
pines as brought about by bank liberalization? Unfortu-
nately, previous country and cross-country studies do not
allow for a determination of the exact degree of competi-
tion. While they point some relationship between firm
concentration and returns, they do not draw a sharp
benchmark for competitive returns (Shaffer 1993). How
much drop in interest margins, for instance, would qualify
as signifying a shift from an oligopolistic or monopoly
industry structure to perfect competition. Moreover, many
other factors like macroeconomic variations, tax policies,
quality of information and judicial systems as well as bank-
specific characteristics like risk preferences or scale of
operations, affect bank profitability and margins. For ex-
ample, during the 1997 Asian crisis, bank profits declined.
But was it the result of earlier liberalization or merely of
adverse macroeconomic condition? Thus, these indica-
tors are deemed inadequate to derive conclusions on
change in competition in the banking market system
(Claessens and Laeven 2003).
In view of this, Pasadilla and Milo (2004), whose results
are summarized in this Notes, venture on a different meth-
odology, the Panzar-Rosse (PR) method, to measure the
competitiveness in the banking sector. The method uses
the structural, contestability approach along the lines pur-
sued in the industrial organization literature and uses
highly disaggregated bank-level data.
The PR method measures market power by the extent in
which changes in factor or input prices are reflected in
The financial liberalization in the 1990s, which allowed entry of foreign banks and eased restrictions
on bank branching, appears to have aided the increase in competition among Philippine banks
despite the increasing trend in concentration from bank mergers. The finding that Philippine
banking industry is close to being perfectly competitive means that further consolidation in the
banking sector, which is encouraged by the BSP, would not severely undermine market competition.No. 2004-11 3
Policy Notes
1990s, which allowed entry of foreign banks and eased
restrictions on bank branching, appears to have aided
the increase in competition among Philippine banks de-
spite the increasing trend in concentration resulting from
bank mergers.
The industry market structure remains characterized by
the presence of a few very large expanded commercial
or universal banks and a lot of very small banks in the
fringe. Yet, the computation of herfindahl index, a mea-
sure of industry concentration showing values far below
one, does not point to any undue banking concentration
(Figure 1). However, an increase in concentration can be
noted in the latter part of 1990s as a result of mergers
of several big commercial banks.
In analyzing a market from a structure-conduct-perfor-
mance perspective, the decrease and subsequent rise
in market concentration should result in a corresponding
change in the degree of competition, i.e., toward less
revenues. The theory is that under monopoly, an increase
in input prices will increase marginal cost,1 reduce out-
put, and consequently reduce total revenue or leave it
unchanged. Under perfect competition, and when banks
are in their long-run equilibrium, a proportional increase
in factor prices induces equiproportional changes in gross
revenues, no change in output volume, and a price rise
in the same extent as the input price.
Meanwhile, monopolistically competitive firms, like a
monopoly firm, face immediate output reduction from an
input price increase. The resulting losses and exit by some
firms, however, shift the demand curve of the represen-
tative firm upwards until equilibrium (tangency of aver-
age cost curve with demand curve) is re-established.
Thus, total revenue may decrease or increase less than
proportionally to unit change in all factor inputs.
The implementation strategy for the PR method is to com-
pute for an index called the H-statistic. The correspond-
ing H value under monopoly con-
dition is negative or zero; under
perfect competition, it is one;
and in monopolistic competition,
strictly between zero and one.
The H-stat value can also be di-
rectly interpreted as an inverse
measure of the degree of mo-
nopoly power, with higher values
(closer to 1) implying greater
competition.
Is there increased
competition?
This author’s study finds that the
financial liberalization in the
________________
1 In fact, a 1 percent change in all
factor prices will result to a 1 percent
upward shift in all of the firm’s cost
curves: average, total, marginal.
Figure 1. Measures of commercial bank asset share and concentration,
1980-2003
0
10
20
30
40
50
60
70
80
1
9
8
0
1
9
8
5
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
Year
A
s
s
e
t
 
S
h
a
r
e
 
(
%
)
0.000
0.020
0.040
0.060
0.080
0.100
0.120
I
H
Top 3 Top 5 Top 1 0 HIDecember 2004 4
Policy Notes
is steeper competition among banks in the loan granting
business than in fee-generating ones.
As to the trend in the H-statistics, Figure 2 shows that H-
stat value increased in the latter half of 1990s, implying
that competition has increased during this period. Divid-
ing banks into different subgroups, however, shows a
different trend in competition. First, if banks were divided
into those that belong in the top 10 in terms of assets,
and those that are not in the top 10, the biggest banks,
as seen in Figure 3, tend to exhibit a decline in competi-
tion (with inverted U shape) and are more monopolisti-
cally competitive, shown in H-statistic values that are posi-
tive but are significantly less than one. In contrast, small
banks are highly competitive (h-stats are close to one)
and are shown with increasing competition in the latter
half of 1990s.2
competition. However, this does not seem to always hold
because alternative conditions that can undermine the
market structure and competition link exist. One such
condition is market contestability. The threat of entry
present in contestable markets can enforce competitive
conduct without regard to the number of firms or market
concentration. On the other hand, collusive actions can
be sustained even when there are many firms. This ex-
plains why, despite the increase in concentration from
the mergers, competition seems not to have declined
but rather improved, as discussed below.
The PR method computation yields fairly high values of
H-statistics that imply the behavior of Philippine banks to
be close to being perfectly competitive. Despite the pres-
ence of few large commercial banks, the method dis-
closes no monopoly or oligopolistic behavior. Furthermore,
it can be noted that, if the dependent variable is the in-
come from loans and not total income of banks, the H-
stat values are generally even higher, implying that there
________________
2 However, when we use income from loans as dependent vari-
able, even big banks show perfectly competitive behavior.
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
H
-
s
t
a
t
Total Income
Loan income
Figure 2. Time varying H-statistic, full sampleNo. 2004-11 5
Policy Notes
Similarly, dividing banks into universal and ordinary com-
mercial banks shows a behavior of monopolistic compe-
tition for universal banks and of perfect competition for
the ordinary ones. Moreover, while universal banks de-
creased competition in the latter half of the 1990s, ordi-
nary commercial banks in-
creased competition (Figure 4).
Finally, in dividing banks into
merged banks and non-merged
banks, the results show in Fig-
ure 5 that merged banks, as a
group, exhibit increased com-
petition, the same as the
nonmerged banks. While at
first glance, this appears like a
puzzle, the fact that mergers
did not only involve big banks
but also small commercial
banks can explain why merged
banks, as a group, did not be-
come less perfectly competi-
tive. Moreover, the fact that the
small banks are providing com-
petition to big banks explains
why competition did not dete-
riorate despite the increasing
consolidation trend shown by
an increasing herfindahl index.
Implication for policy
What does the above result im-
ply for central bank policy on
bank consolidation? The result
is quite supportive of further
consolidation in the Philippine
banking industry. First, be-
cause the herfindal index
points to no undue concentra-
tion. Second, because the
starting level of competition in
the banking industry is high.
Granted that further mergers
can reduce competition, the level of competition would
still remain high, albeit somewhat smaller.
Thus, from an industry competition standpoint, there is
nothing to fear from bank consolidation. However, whether
0.3
0.5
0.7
0.9
1.1
1.3
1.5
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
full sample
ordinary commercial banks
universal banks
Figure 4. H-statistics of universal vs. commercial banks
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
full sample
top ten banks
non-top ten banks
Figure 3. H-statistics of top 10 vs. nontop 10December 2004 6
Policy Notes
such consolidation would, in fact, improve efficiency is a
different story. But, then, this is a topic of another pa-
per.      
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For further information, please contact
The Research Information Staff
Philippine Institute for Development Studies
NEDA sa Makati Building, 106 Amorsolo Street
Legaspi Village, 1229 Makati City
Telephone Nos: 892-4059 and 893-5705
Fax Nos: 893-9589 and 816-1091
E-mail: gpasadilla@pidsnet.pids.gov.ph; jliguton@pidsnet.pids.gov.ph
The Policy Notes series is available online at http://www.pids.gov.ph.
Reentered as second class mail at the Business Mail Service Office
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0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
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Bank regulation and supervision: what works best?”

Chamberlin vs. Robinson: an empirical test for monopoly rents.

Effect of liberalization on banking competition.

Reentered as second class mail at the Business Mail Service Office

Regulations, market structure, institutions, and the cost of financial intermediation.

Structure, conduct and comparative statistics.

Testing for ‘monopoly’ equilibrium. Journal of Industrial Economics 35:443-456. For further information, please contact The Research Information

The price-concentration relationship in banking.

What drives bank competition? some international evidence. World Bank Policy Research Working Paper 3113.

Measuring Bank Competitiveness: Has Financial Liberalization Increased Competition?

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Measuring Bank Competitiveness: Has Financial Liberalization Increased Competition?

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