Market entry, privatisation and bank
performance in transition
Steven Fries, Damien Neven,
Paul Seabright and Anita Taci
EIASM Workshop on Financial Development
Prague, 26 May 2006
Introduction

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 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 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)

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 function

Accounting identity
i  rilLi - ridDi + rinNi - R(Li + Ni - Ei - Di) - C(Di,Ni,Li,Wi)
Loan
margin
Deposit
margin
Non-loan assets
margin
Operating costs
i  (ril - R)Li + (R - rid)Di + (rin - R)Ni + Rei - C(Di,Ni,Li,Wi)
Interbank rate

Equilibrium determination of loan and deposit
margins in monopolistically competitive markets
The empirical specification

Revenue function is therefore
REVijt = Mijtl(•)Likt + Mijtd(•)Dikt + ρNijt + σEijt + ijt


Margins are a function of number of
competitors, market shares and bank
ownership
Combine loans and deposits into a single
scale variable because of their co-linearity
REVijt = Mijtl+d(•)(Likt + Dikt) + ρNijt + σEijt + εijt
Empirical specification (cont’d)

Trans-log specification for costs
lnCijt = αo + Σst βs lnQs,ijt + Σmn Xm lnWm,ijt

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
Dataset

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 revenues

Revenues to total assets in per cent
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
New domestic
1995-98
New foreign
Privatised
domestic
1999-2001
Privatised
foreign
State owned
2002-04
Basic data on bank costs

Operating costs to total assets in per cent
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
New domestic
1995-98
New foreign
Privatised
domestic
1999-2001
Privatised
foreign
State owned
2002-04
Results – Revenue equation
(revenue adjusted for inflation)
1995 - 1998
1999 - 2001
Loans
0.0320***
0.0194
-0.0350***
Deposits
0.0007
0.0609***
0.0475***
Newly established, domestic
-0.0096
0.0095***
0.0105***
Newly established, foreign
-0.0184***
-0.0094***
0.0081***
Privatised, domestic
0.0199***
0.0275***
0.0282***
Privatised, foreign
0.0052**
0.0051**
0.0038***
Number of banks per million of population
-0.0005
-0.0012**
0.0002
Share of loan and deposit market
0.0015***
0.0289***
0.0063*
IAS dummy variable
-0.0101
-0.0289***
-0.0089**
Non-Loan financial assets
0.0125
0.0391***
0.0194***
Equity
0.2408***
0.2749***
0.2906***
2002 - 2004
Explanatory variables
Interacted with loans plus deposits
Results – Cost equation
1995 - 1998
1999 - 2001
2002 - 2004
Ln (loans + deposits)
0.7995***
0.6101***
0.6332***
Ln (loans + deposits ^ 2
0.0021
0.0360***
0.0410**
Ln (operating costs / total assets)
0.3681***
1.3556***
0.9657***
Ln (operating costs / total assets) ^ 2
0.1715***
0.2036***
0.0370*
Ln (non-loan financial assets)
0.0331
0.1075***
0.0529***
Equity to total assets ratio
-0.0019
-0.1170
0.3072**
Newly established, domestic
-0.2649***
-0.0833*
-0.0298
Newly established, foreign
-0.3767***
-0.0051
0.0303
Privatised, domestic
-0.2767***
-0.0340
0.0083
Privatised, foreign
-0.0209
0.0263
-0.0377
Marginal costs and mark-ups

Foreign bank marginal costs below that of state bank
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
New domestic
1995-98
New foreign
Privatised, domestic Privatised, foreign
1999-2001
2002-04
Marginal costs and mark-ups

Mark-ups above state bank benchmark
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
New domestic
1995-98
New foreign
Privatised, domestic
1999-2001
Privatised
2002-04
Conclusion


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)