Market Competition, Efficiency, Shareholder Value and Risk-Taking in the Australian Banking Sector

Abstract

<p>The banking sector is the most significant part of the financial system in Australia. It currently includes 148 depository institutions, called authorised deposit-taking institutions (ADIs), which hold approximately 55 per cent of the assets of Australian financial institutions. The well-functioning banking sector has contributed substantially to the country’s economic growth and stability1.</p> <p>Since 1990, the Australian banking sector has been characterised by high market concentration resulting from the “Four Pillars policy. Four major banks hold roughly three-quarters of the total assets held by the whole sector, while high market concentration is an indicator of the likelihood of less competition and greater market power. Competition in the banking sector impacts on the functioning of depository institutions (Maudos & de Guevara, 2007). In the Financial System Inquiry of 2014, some smaller ADIs and non-bank lenders highlighted that the increasing concentration and integration of the major banks had harmed competition. They contended that the market power of the major banks was oligopolistic, stifling competition and ensuring higher prices for consumers. The mission of the current banking royal commission isto scrutinise the financial system, especially banking, to maintain stability, competitiveness, transparency, and accountability, critical factors of a well-functioning banking sector.</p> <p>Accordingly, this study aims to provide insights into the factors affecting the functioning of the Australian banking sector for the period 2000–2015, by a comprehensive analysis of market competition, performance, efficiency, and risktaking, to emphasise their interlinkages. This period included the global financial crisis (GFC) of 2007–2009, which has had a profound impact on global financial systems, especially banking. All types of Australian depository institutions are considered in this study, including banks, building societies, credit unions and other ADIs.</p> <p>Using an unbalanced panel data of 73 Australian depository institutions for the study period, this thesis addresses three main research questions. (1) How have efficiency and productivity growth been improved in the banking sector? (2) How have the competition and efficiency of depository institutions impacted on their performance in terms of shareholder value? (3) How are risk–taking incentives of Australian depository institutions affected by their market power and government regulations promoting competition?</p> <p>Using the intermediation approach described in banking efficiency literature, the analysis of the first research question employs the stochastic frontier analysis (SFA) technique to estimate banking efficiency and productivity growth. The empirical findings suggest that the Australian banking sector lacked technical efficiency, especially during and after the GFC. Although the sector demonstrates gain from economies of scale, the four dominant banks exhibit diseconomies of scale. Therefore, despite significant technical progress, banking sector productivity growth has decreased over the observed period. </p> <p>The analyses of the second and third study questions are based on banking competition literature and employ a two-step system generalised method of moments (GMM) estimation for dynamic panel data models, to investigate the performance and risk-taking of Australian depository institutions.</p> <p>In the second analysis, examining bank performance in terms of shareholder value, the structure – conduct – performance (SCP) and efficient structure (EFS) hypotheses are tested in the Australian banking context. The SCP hypothesis is a theory of collusion, which posits that the more concentrated the market, the easier it is for big banks to collude in earning superior profits (Casu, Girardone, & Molyneux, 2015). Conversely, the EFS hypothesis asserts that big banks tend to make higher profits due to their greater efficiency, rather than oligopolistic behaviour (Demsetz, 1973). Four alternative proxies of shareholder value: net interest margin (<i>NIM</i>), return on equity (<i>ROE</i>), Tobin’s q ratio and the economic-value-added ratio (<i>EVAR</i>) are used in the models. All empirical results support the <i>EFS</i> hypothesis, implying that Australian depository institutions earn higher profits and create higher value for shareholders due to their superior technical efficiency. Thus, these outcomes also confirm that the oligopolistic nature inferred from the high market concentration may not harm smaller competitors.</p> <p>The third analysis examines the risk-taking incentives by testing two opposing emergent views on banking stability, “competition–fragility” and “competition–stability”. The competition–fragility view argues that competition makes banks more likely to take excessive risks, thereby leading to fragility, while the competition-stability view suggests that competition can enhance the stability of a depository institution, promoting efficiency and market power. Market-based and accounting-based risk indicators, namely loan loss provision to gross loans, Z-score, and distance to default were used to measure the credit and insolvency risk exposures of the individual depository institution. Both market concentration and pricing power were included in the models to determine their impacts on risk-taking incentives in the Australian banking sector. The empirical findings suggest a neutral view; market concentration promotes the “competition-fragility” view, while market power promotes the “competition-stability” hypothesis. These results imply that in the highly concentrated Australia banking market, depository institutions face less competitive pressures and, hence, have less motivation to take credit and insolvency risks. Alternatively, the empirical results also imply that an Australian depository institution with more pricing power exploits its advantage to render the market less competitive and has greater incentive to take these risks. These findings also demonstrate that measures of bank competitiveness include the market concentration, as well as the market power, of individual depository institutions.</p> <p>The significant contribution of this thesis is the empirical evidence that advances the understanding of the relationships between competition, shareholder value, efficiency, and risk-taking, to support the development of new regulations. Key results suggest that no simple relationship exists between competition, shareholder value, efficiency, and risk-taking; therefore, policymakers should account for such differences, whether through bank-specific, industry-specific, or macroeconomic factors.</p>