Bank Competition and Access to Finance

In a recent blog post, I talked about whether there are trade-offs between bank competition and financial stability.  But what about access to finance?  What does competition imply for access?

Theory supplies conflicting predictions, as usual.  According to standard economic theory, a banking system characterized by market power delivers a lower supply of funds to firms at higher cost; hence greater competition improves access.  However, several theoretical contributions have shown that when we take into account problems of information asymmetry, this relationship may not hold.  For example, banks with greater market power can have more of an incentive to establish long-term relationships with young firms and extend financing since the banks can share in future profits.  In competitive banking markets, however, borrower-specific information may become more dispersed and loan screening less effective, leading to higher interest rates. Indeed, while it has been shown that concentration may reduce the total amount of loanable funds, it may also increase the incentives to screen borrowers, thereby increasing the efficiency of lending.  However, all these models also assume a developed economy, with a high degree of enforcement of contracts and developed institutional environments in general. This is obviously not the case for most of the countries where the Bank works.

What about empirical results?  The relationship between bank competition and access is an active area of current research.  We often analyze the level of competition in banking and try to ascertain its implications for access as well as stability within the context of our on-going country-by-country Financial Sector Assessment Program.  Day by day, we are learning quite a bit from these interesting case studies.  But let me mention results from a cross-country study that Thorsten Beck, Vojislav Maksimovic and I have written on this topic as an example.  In this paper, we use enterprise survey data for 74 countries to assess the effect of banking market structure on the access that firms have to bank finance.

Specifically, we use survey data on the financing obstacles perceived by firms and relate these data to the competitive environment in the country’s banking market.  To measure competitiveness, we use (1) the market share of the largest three banks and (2) regulatory policies that influence the competitive framework in which banks operate, such as share of bank license applications rejected and restrictions on banks’ activities.  We control both for the ownership structure and the institutional environment.  We assess the impact of the market structure on firms of different sizes, while at the same time controlling for a large number of other firm characteristics.

Our results indicate that in more concentrated banking markets, firms of all sizes face higher financing obstacles.  This effect decreases as we move from small to medium and large firms.  Furthermore, there seems to be an important interaction between bank concentration and: (1) the regulatory and institutional country characteristics; and, (2) the ownership structure of the banking system.  The relationship between bank concentration and financing obstacles turns insignificant in countries with high levels of GDP per capita, well-developed institutions, an efficient credit registry, and a high share of foreign banks.  In contrast, public bank ownership, a high degree of government interference in the banking system, and restrictions on banks’ activities all exacerbate the impact of bank concentration on financing obstacles.

What do these results imply?  These findings support theories that suggest market power is associated with less access, especially for developing countries.  For the most part, we don’t find any evidence consistent with theories that predict a positive impact of bank concentration and market power on alleviating financing obstacles for small firms and allowing them access to credit.

So overall, bank competition seems to be good for access. Further work could investigate whether these relationships hold if we use more sophisticated measures of bank competition – such as the Panzar and Rosse H statistic, the Lerner index of market power, or the Boone indicator of competition – and more expanded firm-level data bases.

Further reading:

Beck, Thorsten; Asli Demirguc-Kunt and Vojislav Maksimovic, “Bank Competition and Access to Finance: International Evidence,” Journal of Money, Credit and Banking, Vol. 36, no. 3 (June 2004, part 2). (Ungated version available here.)