[2016-2] Level of Competition in the Banking Industry and Its Influence on Financial Stability

Competition Loans Deposits Increasing Korean Mergers Liquidations Asian
Research Department

   Healthy competition among financial institutions reduces monopoly profits, thus increasing financial consumers’ welfare and contributing to the development of the financial industry. However, if competition is not accompanied by the innovation and development of new financial instruments and is focused instead on increasing market share and cutting prices, it may have a negative influence.

   In the Korean banking industry, although the number of banks has declined sharply since the Asian currency crisis from liquidations and mergers, most of their businesses have become concentrated on deposits and loans, with competition in the lending market in particular becoming fiercer since the 2000s after business conditions worsened. This increased lending competition among banks may have influenced to some extent their operations.

   Against this backdrop, this paper assesses the level of competition in the banking industry from 2000 to 2015, empirically analyzing the impact of competition on banks’ management soundness. Using the Panzar-Rosse model, this paper estimates the Korean banking industry to be a monopolistically competitive market that is close to perfect competition. In addition, a panel data regression model estimating the relation between individual banks’ level of competition (level of competitive business practices indicated by the Lerner index) and management soundness shows that as an individual bank’s level of competition increases, the higher its NPL ratio and default probability become. This shows that, if the bank lending market becomes more competitive, this may negatively affect Korean banks’ soundness and profitability, since their main revenue source is lending.

  These analysis results have a few implications for the direction of development in the banking industry.
  First, competition among banks should depart from loan expansion and interest rate competition, and spread to various areas of operation that correspond to a new financial environment. In addition, domestic banks should follow global banks in diversifying their operations to include corporate financing, financial investment and asset management, thereby preventing competition among banks from concentrating on lending only.

  Meanwhile, banks need to examine whether they are underestimating risks in the course of their lending competition. Finally, all fields should take an interest in the impact of competition in the lending market on the entire financial system from a macroprudential perspective.

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