Indian Banking System- A Monopolistically Competition

Abstract :-

Competition in banking is important, primarily forproductivity, efficiency, consumers’ welfare and overalleconomic growth of a country. Since 1991, Indian governmentand the financial system regulator have initiated many policymeasures so as to enhance the efficiency and stability of theIndian Banking Sector. The policy measures have reduced theassets concentration of public sector banks, improved customerservices and customer profitability. The article has used PRHstatistic and assessed the degree of competition of the IndianBanking Sector after the penetration of private and foreignbanks in India. It has used a dynamic panel data involving 75domestic and foreign banks and found that the Indian BankingSector is monopolistically competitive having a few bigger sizebanks, both in Public Sector and Private Sector, influencingthe market conditions and pricing system.

INTRODUCTION :-

Prior to reforms, Indian Banking Sector was functioningin a highly regulated environment. Controlled interest rate,pre-emption of credit, high Statutory Liquidity Ratio (SLR)and Cash Reserves Ratio (CRR) requirements were puttingpressure on efficiency and financial stability of the bankingsector. Profitability of Indian Banks was extremely lowdespite rapid growth in deposits. The survival of IndianBanking System was questioned as a consequence of erosion

Of capital, which led to the appointment of the newCommittee on Financial System (CFS) in 1991. Pursuant tothe recommendations of the Committee, gradual reformmeasures were initiated to improve efficiency, productivity,competition and stability of the banking sector. BaselCommittee recommendations on income recognition, assetclassification, provisioning, capital adequacy and supervisionwe are introduced in a phased manner. There have beensignificant changes in the competitive conditions in theIndian Banking System with the diversification of ownershipof public Sector Banks and flexible entry norms for privateand foreign banks. Competition has energized the IndianBanking industry which led to product innovation, enhancedcustomers’ services and new business practices. The reformmeasures, over the years, have improved efficiency,competition and financial stability of the banking sector. Theprudential regulations have aligned the Indian BankingSector with the market forces and allowed them to integratewith the world financial system. Indian Banks are now well placed compared to their counterparts in the developed countries.

The article seeks to estimate the degree of competition inthe Indian Banking Industry using a panel data structure.

INDIAN BANKING SECTOR- A RETROSPECT :-

Government intervention in the Indian banking sectorhad its origin in nationalist thinking. Colonial banking wasperceived to be biased in favour of the working capital loansto trade and large capitalist enterprises, and against ruralareas and the common man. This legacy combined withsocialist ideology culminated in the nationalization of all thelarge banks in 1969. The nationalized banks were explicitlyset quantitative targets to expand their network in rural areasand to direct credit to priority sector. Over times, banks alsobecame a major source of lending to the government and

thus of financing fiscal deficits. By 1991, the country hadcreated an unprofitable, inefficient and financially unsoundbanking sector. Indian banking sector was operated under ahighly regulatory environment. Under law, Indian bankswere obliged to maintain high reserve requirement (CRR andSLR). In 1991 the SLR and CRR, in total, were 52% of theirdeposits. The banks were also required to direct 40% of theiradvances to certain priority sector at low interest rates.Virtually all interest rates offered and charged by banks werestipulated by the Government. Thus, a staggering 63.5% ofbank deposits were compulsorily captured by the RBI andthe Government. Credit planning and rationing of credit wereinevitable to achieve the objectives of monetary policytogether with social obligations. As the interest rates wereadministered, the system became unduly complex overtime.The allocative efficiency was grossly undermined due todirected credit as also directed investment. The bankingsystem had serious survival problem due to lack of profit andconsequent erosion of capital. Besides these, low internal andorganizational efficiency, lack of competition and politicalinterference were other factors, because of which thebanking sector in India was in a state of bankruptcy. ACommittee on the Financial System under the chairmanshipof Narasimham was appointed in August 1991. Majorproblem faced by the banking system was on account ofconstraint mainly in terms of massive pre-emption of banks’resources to finance Governments’ budgetary needs andadministered interest rates. Removal of these constraintsmeant a planned reduction in statutory pre-emption and agradual deregulation of interest rate prescriptions. Pursuant to the recommendations of the Committee, prudentialregulations such as income recognition, asset classifications,and provisioning and capital adequacy have beenimplemented for the banks, financial institutions as well asfor non-bank financial companies in a phased manner. Bothdeposit and lending rates are substantiallyderegulated/rationalised. Directed investment by way of

SLR has been reduced. The element of cross-subsidy hasbeen reduced considerably over time. Commercial bankshave been given functional autonomy with respect to theirloan appraisal. Basel Committee recommendations ofprudential system of recognition of income, classification ofassets, provisioning of bad debts, capital adequacy normsand internationally accepted accounting practices wereintroduced in a phased manner. A comprehensive ratingsystem, based on Capital Adequacy, Asset Quality, Earnings,Liquidity and Systems (CAMELS) methodology has beeninstituted for banks. Commercial banks in India have beenallowed to increase their capital adequacy by going fordilution of their equity capital and also by long-term capitalborrowing. The Indian government has infused completionin the Indian Banking System by initiating a liberal policymeasures towards entry of domestic private banks andforeign banks. Greater public ownership of banks andmandate public disclosures of balance sheets, lead to moremarket-based assessment of performance of banks.Reform measures over the years have reduced the marketshare of public sector banks, in total assets, from 90% in1991 to 70% in 2008. The entry of new banks in privatesector has reduced the asset concentration which indicatesstrengthening of competition in the Indian Banking System.The primary objective of the Banking Sector liberalization inIndia has been enhancement of efficiency and productivitythrough greater competition. The article has adopted a formalapproach to examine level of competition in Indian BankingSector after the liberalization and subsequent penetration ofprivate and foreign banks.

ASSESSMENT OF COMPETITION IN BANKING- A METHODOLOGICAL APPROACH :-

Empirical assessment of degree competition in marketare developed by Breshanan [1], Lau[2] and Panzar and

Rosse[3]. The Breshanan model is a general marketequilibrium model where the profit-maximizing firms wouldselect their prices and quantities at that level where marginalcosts equal to their perceived marginal revenue. On the otherhand, the Panzar –Rosse H-Statistic (PRH) examines therelationship between change in factor input prices andrevenue earned by specific bank. PRH develop a test thatexamines whether firm-level conduct is in accordance withthe textbook models of perfect competition, monopolisticcompetition, or monopoly. The PRH-statistic is the sum ofthe elasticities of a firm’s total revenue with respect to itsfactor input prices. H- represents the percentage variation inthe equilibrium revenue resulting from a unit percentageincrease in the price of all factor inputs. The standardprocedure for estimation of the H-statistic involves theapplication of fixed effects (FE) regression to panel data forindividual firms. Under this procedure, the correct identification of the H-statistic relies upon an assumption that markets are in long-run equilibrium at each point in time when the data are observed. The panel data fixed effect revenue function can be written as follows:

In (Ri,t) = αi+β1 In (W1, i,t)+ β2 In (W2, i,t) + β3 In (W3,i,t) + xi,t Υ+ ei,t ---------(1)

where i indexes banks and t indexes time. Ri,t is financialincome as a measure of the revenue for bank i in year t; Wj,i,tis the price of factor input j (j = 1 for financial expenses, j =2 for administrative and operating expenses, and j = 3 forpersonnel expenses), all measured as the ratio of each typeof expense to total assets. xi,t is a vector of exogenouscontrol variables at the bank level, which includes the ratioof equity to total assets, the ratio of net loans to total assets,and the ratio of other income to total assets. αi is an

individual bank effect, and ei,t is a random disturbance term.In the equation, the PRH statistic is given by the sum of theelasticities of revenue with respect to input prices, (β1+ β2+β3). Under monopoly, PRH < 0; under perfect competition,PRH = 1; and under monopolistic competition, 0 < PRH < 1.As in Vesala [4] and Bikker and Haaf [5], it can beinterpreted that the estimates of the PRH statistic asproviding a continuous measure of the level of competition,with larger values indicating stronger competition.Although the microeconomic theory underlying theRosse–Panzar test is based on a static equilibrium framework,in practice adjustment towards equilibrium might be lessthan instantaneous, and markets might be out of equilibriumeither occasionally, or frequently, or always. Goddard andWilson [6] suggest for a dynamic panel data structure to adynamic model of the revenue function. They advocate forpartial adjustment towards the long-run equilibrium with alagged dependent variable in the revenue equation.

In (Ri,t) = αi + β0 In (Ri,t-1)+β1In (W1, i,t)+β2In (W2, i,t) +β3In (W3,i,t) + xi,t Υ+ ei,t ------------(2)

Total Revenue as a percentage to Total Assets isconsidered as the dependent variables. IndependentVariables are Employee Expenses, Administrative Expensesand Funds Expenses. One period lagged dependent variablehas been introduced in the equation so as to capture themarket equilibrium.Revenue growth depends upon the growth in credit,investment and other income, which in turn depend upon theavailability of Capital as per Basel-II norms. Hence, the ratioof equity capital to total assets is considered as the controlvariable in the revenue equation.The period of study is spread over 1997 to 2008 and thereare two panel data sets each 6 years. This would help in

indicating the change in competition over time. 75Commercial Banks, involving Public Sector, DomesticPrivate Sector and Foreign Banks have been considered inthe analysis.

RESULTS AND DISCUSSION:-

Competition in Banking leads to progressive decline inthe market shares of public sector banks and subsequentenhancement of market shares of domestic private sectorbanks and foreign banks. As mentioned above the marketshare in deposits and advances of public sector banks hasdeclined from 90% in 1991 to 70% in 2008. This indirectlyindicates the stiff competition in the Indian Banking Sector.The article has used unit cost prices for funds, labour,administrative expenses and capital.

Unit Cost Price for Funds : Ratio of Interest paid onfunds to total funds

Unit Cost Price for Capital : Ratio of interest paidon Tier-II bonds to Total Tier-II Bonds

Unit Cost Price for Labour : Ratio of employeesalaries and provisions to total number of employee

Unit Cost Price for Administration: Ratio ofAdministrative expenses to total assets.

The results indicates there has been progressiveenhancement of competition in the Indian Banking system asthe PRH statistic has improved between periods 1997-2002to 2003-2008. The PRH statistic, though positive, it is lessthan one indicating thereby existence of monopolistic free –entry market conditions. The results rejected the monopolyand perfect competition as PRH is neither zero nor one.

The ratio of equity to assets, as the control variable, issignificant in both periods and thus influencing the growth inthe revenue and thus the competition. Contribution of UnitPrice of Funds to PRH Statistic is significantly high in bothperiods. This also indicates the competition is quite high ingetting low cost funds and which primarily influence therevenu

TABLE I. ESTIMATION RESULTS PANEL REGRESSION

Dependent Variable = Ln (Revenue/Assets)1997 - 2002 2003 - 2008

Constant -3.569(0.151)*

-3.428(0.131)*

Ln (Lagged Dependent)

-1.432(0.02)*

-1.009(0.122)*

Ln (Interest paid/Total funds)

0.451(0.023)*

0.479(0.029)*

Ln(Wage/TotalEmployee)

0.065(0.012)*

-0.011(0.002)*

Ln (Other Expenses/Assets)

0.021(0.001)*

0.051(0.001)*

Ln (Equitycapital/Assets)

0.012(0.007)*

0.038(0.002)*

PRH- Statistic 0.549 0.551Adjusted R-Square 0.972 0.986Total PanelObservations

450 450

Number of Banks 75 75

CONCLUSIONS :-

The article examined the degree of competition in theIndian Banking Sector after the financial sector reforms.Financial sector liberalization has improved the efficiency,productivity and stability of the Indian Banking Sector. Withtwo sub-periods panel data analysis, it is found thatthere has been improvement in the degree of competitionsince 1997. The PRH Statistic, which is positive and lessthan 1, indicates that the Indian Banking System ismonopolistically competitive. It is true and validated the factthat about 70% of the banking system assets in India areowned state-owned banks. It is also found that unit price offunds and administrative expenses have significantcontribution in the PRH statistic. It means that revenuegrowth is highly elastic to the funds cost and administrativeexpenses.

3-YEAR MBA PROGRAMME

(Semester I)

SUBJECT: MANAGERIAL ECONOMICS

PAPER CODE: MBD 103

ASSIGNMENT ON

Indian Banking System- A Monopolistically Competition

SUBMITTED BY

MITHUN SAHA

ROLL NO: BUR/DMBA/JAN 2011/