Implications of bank competition on financial stability, access to finance and monetary policy: Indian perspectives

Abstract

The key objective of this thesis is to investigate the implications of bank competition on financial stability, access to finance, and monetary policy transmission mechanism in one of the fastest-growing emerging economies such as India. Financial liberalization, privatization and rapid deregulation of the banking sector underline the greater attention and policy focus on the lesson of whether competition among banks is beneficial for the development of the financial system. The assessment of bank competition has long been an important issue in banking literature as the formulation of robust competition policies largely depends upon the appropriate measurement of bank competition. Chapter one extends a general introduction of the thesis. We discuss the background of the study and highlight the significance of bank competition both from the global and Indian perspectives. Chapter two presents the theoretical and empirical literature on the implications of bank competition on financial stability, access to finance and monetary policy transmission mechanisms. Chapter three addresses the misspecification issues associated with the widely used Panzar –Rosse model in the Indian banking context. We apply Panzar and Rosse (1987) H-statistic and evaluate the degree of bank competition by estimating the extent to which changes in input prices are reflected in revenues earned by banks. Subsequently, we link this measure of competitiveness to several structural indicators to test the Structure-Conduct-Performance (SCP) hypothesis, which assumes that a concentrated banking system impairs bank competition. Additionally, this thesis measures the degree of bank competition in India using a sample of 70 commercial banks over the period 1996-2016. To assess the degree of competition, we estimate the market power of each bank in our sample employing three non-structural measures, Lerner index (1934), adjusted Lerner index (Koetter et al. 2012) and Boone indicator (2008) or profit elasticity. Bank-wise and year-wise estimates of the marginal cost required in all these measures are obtained using the semi-parametric method. The thesis further attempts to undertake a comprehensive assessment of the competition in Indian banking. It identifies various bank-specific, macroeconomic, structural, and contestability indicators, which are supposed to explain the level and variation of the degree of competition over time. Findings reveal that public sector banks in India exercise a relatively higher degree of bank competition than private and foreign sector banks. However, aggregate results support that the Indian banking system is competitive in general. Unlike the Structure-Conduct-Performance paradigm (SCP), which advocates that a concentrated banking system impairs competitiveness, our findings reveal that concentration measures hardly exerts any effect on bank competition. Instead, contestability measures play a significant role in the determination of bank competition. Chapter four addresses the key research question of whether intensified bank competition promotes financial stability in Indian banking. This chapter empirically investigates the impact of bank competition on financial stability in Indian banking. We use a dynamic panel model to examine whether an increase in bank competition acts as a hindrance in maintaining the financial stability of commercial banks in India over the period 1996 to 2016. Findings reveal that a higher degree of bank competition is positively associated with India's growing incidence of non-performing loans. Additionally, the positive impact of the Lerner index on the Z-score lends support to the competition-fragility view. However, we argue that both the opinions of competition-stability and competition-fragility can coexist in a single banking system like India. The findings of the chapter extend several interesting policy implications for the Indian banking industry. Chapter five investigates the effect of bank competition on the non-financial sector, such as the manufacturing and service sectors. Using a dataset of 9281 firms from the World Bank Enterprises Survey (WBES), this chapter investigates the potential role of bank competition in mitigating credit constraints and providing access to finance to firms in India. The direct connection between bank competition and a firm's access to finance is further enhanced by the degree of financial development, firm-specific and macroeconomic indicators across 23 Indian states. We estimate bank competition using the market share of the bank-branch statistics in each state and calculate the market share of public and private sector banks, respectively. Results obtained through the application of the probit model with sample selection (PSS) and Two-Stage Least Square (2SLS) indicate that bank competition promotes firms' access to finance and positively impacts a firm's decision to apply for a bank loan. Findings further reveal that small and medium-sized firms are more credit constrained, and public sector banks play the dominant role in reducing firms' financing constraints compared to private sector banks. Chapter six of the thesis theoretically and empirically investigates the effect of bank competition on the monetary policy transmission mechanism through bank lending channel in India over 1996 to 2016. Additionally, the chapter captures the response of varying degrees of bank competition to the monetary policy changes across heterogeneous bank ownerships. Results obtained through the two-step system-GMM reveal that a higher degree of market power dampens the monetary policy transmission mechanism for the whole banking industry and across ownerships. The robustness of the main findings has been further confirmed by alternative competition indicators and monetary policy instruments. The robustness results appear highly consistent with our main findings. The findings extend several important policy implications for India and other emerging economies that witnessed recent financial liberalization and experienced thriving bank competition. Chapter seven concludes the thesis by discussing the main findings, providing several policy implications relevant not only for India but also for other emerging economies that witnessed the financial sector reforms in the early 1990s. We also highlight the limitations of the study and extend some future research agendas.