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Theories On The Cost Of Financial Intermediations

Bank, considered as the intermediation between the providers and users of financial capital, is always playing a quite important role in global economy, with the efforts of keeping and balancing capitals in the market, as well as encouraging economic development and trade growth. People, not only those professional in financial market, like investors, shareholders and economists, but also those customers, the public; even the government have paid more interest on bank performance (Fethi and Pasiouras, 2009). Theories of intermediation, particularly the cost of intermediation, which reflects pure operational efficiency and competitive nature of banking market, have attracted increasing amount of attentions in recent decades. The measurement of cost of intermediation contains two main criteria: bank net interest margins, which refers to the gap between the payment to its funds’ providers and the receiving from firms and other users of those bank credits. The other is bank overhead expenditures, which refers to the ratio with bank overhead cost divided by its total asset (Demirguc-Kunt, Laeven and Levine, 2004). According to empirical studies, there are three major aspects of factor will probably affect the cost of financial intermediation: regulation, market structure and institutions.

This article will firstly explain the empirical studies and theories of cost of financial intermediations. Secondly, in sub-section 3.1-3.3 respectively, it will explains the major theories and key arguments about the impacts of bank regulations, the institutional environment and bank market structure sectors on net interest margins and overhead expenditures. Further possible important factors will be discussed in section 3.4 and finally to sum up in section 4.

Section 2. Literature Review

According to King and Levine (1993), who firstly indicate the idea and then followed by array of authors that the size and efficiency of financial markets and institutions can have a significant impact on long-term economic growth. Those industrial sectors may benefit more from external capital sources from advanced finance rather than internally generated funds (Rajan and Zingales, 1998). Moreover, a rapid development and economic growth probably results from financial liberalizations (Jayaratne and Strahan, 1996; Bekaert, Harvey and Lundblad, 2003). Those significant relationships between banking market and economic growth drive people to consider more about the possible determinants of bank efficiency, in order to boost economy.

There are numerous empirical studies of the relationship among regulations, concentration, institutions and bank efficiency. Theories differ mainly from the incongruous beliefs about the causes of bank concentration. A major view consists that regulations create an uncompetitive and monopolistic environment for banking market and those powerful banks can impediment competition with inefficient operations (Demirguc-Kunt, et al., 2004). In this point of view, high degree of concentration is considered as a signal of uncompetitive and inefficient market. Moreover, since the trend of globalization, scope economies can also lead to a monopolistic banking structure (Diamond 1984; Boyd and Prescott, 1986).Most evidence results from researches on US banking industry about banking structure and efficiency, suggest that, banks in high concentrated market more probably have higher overhead expenditures and loans, and lower deposits, as well as a slower response to Federal Reserve reductions in interest rates (Neumark and Sharpe, 1992; Berger and Hannan, 1998). Many other researchers hold that business activities such as mergers and acquisitions which may cause increasing in bank concentration can results in lower deposits and high profitability (Prager and Hannan, 1999; Simons and Stavins, 1998; Pilloff, 1996; Petersen and Rajan, 1994). An alternative theory argues that those powerful banks with larger market share succeed mainly due to high efficiency with lower overhead expenditures, after a period of fully competition (Demsetz, 1973; Peltzman, 1977). The interest rates gap between borrowing and saving are narrower in more concentrated banking market (Graddy and Kyle, 1979; Smirlock, 1985) and firms feel less credit constrained (Peterson and Rajan, 1994).

A third ‘institutional view’ appeared since the most recent decade, pointing out that bank regulations and concentrations reflect broader institutional characteristics rather than representing independent determinants of bank efficiency. A lot of literature support that most financial institutions can restrict competition level and protect those stronger ones, hence a maintenance of high concentration (Engerman and Sokoloff, 1997; Acemoglu, Johnson, and Robinson, 2001; Haber, Razo, and Maurer, 2003; Beck, Demirguc- Kunt, and Levine, 2003). Quite mixed results are found, and as Berger (1995) concludes that the relationship between market concentration and bank efficiency need to be critically analyzed by holding what other variables constant. According to Demirguc-Kunt, Laeven and Levine (2004), concentration has positive relationship with the net interest margins, however, such impact will disappear if controlling for regulatory impediments to competition and inflation.

In order to better assess the impact of bank regulations, the usefulness of concentration as a signal of competition, and consider the role of national institutions with respect to shaping regulations and market structure, it is essential to examine determinants individually under distinct regulatory and institutional environment (Demirguc-Kunt et al, 2004). However, most of empirical studies are based on US banking market, which lack for typicality and comparability while with regarding to the global extent. Demirguc-Kunt et al’s study (2004) is epoch-making as the first one measure the relationship with bank regulations, market structure and institutions with net interest margins and bank overhead expenditures through ‘a broad cross-section of countries while controlling for bank-specific factors (for example, bank size, equity, fee income, liquidity and risk, etc.) and cross-country differences in macroeconomic and financial sector conditions’.

Section 3. Determinants of cost of financial intermediation

§3.1 Bank Regulatory Restrictions

Acting as the important intermediation of funds providers and capital borrowers, regulations and supervision are created to deal with the possible interest rate conflicts existing within the banking entities (Santomero, 2002). Bank regulations are considered as the efficacies of: (1) reducing or even eliminating interest conflicts, (2) easing moral hazard, (3) enhancing monitor efficiency, (4) supervising large financial groups, and (5) boosting financial stability (Barth, Caprio and Levine, 2001a, 2003; Demirguc-Kunt et al., 2004). Controlling for bank concentration, bank-specific factors constant and the rate of inflation, the assessment of bank regulations can includes the following four aspects: fraction of entry denied (a country’s willingness to allow foreign bank entry), activity restrictions (eg., securities activities, insurance, owning or controlling commercial enterprises), reserve requirements and banking freedom (overall measurement of the openness of the banking industry and the extent to which banks are free operated) (Barth et al., 2001b, 2003; Demirguc-Kunt et al., 2004; Fethi and Pasiouras, 2009).

Questions arise from the degree of bank regulations at which it can benefit bank performance efficiency and profitability and hence lead to economic growth. According to Demirguc-Kunt et al. (2004), bank regulations play a significant role in explaining the cost of financial intermediation. Tighter regulatory restrictions in general can boost the bank net interest margins. Since the net interest margin is a key element of bank’s net income/assets, in that case, a higher net interest margin represents higher profitability. Hence, tighter bank regulations which will lead to increasing net interest margins can be considered as a method to mitigate banks’ pressure of suffering financial losses (Dewatripont and Tirole, 1994). Moreover, according to Fernández, González and Suárez’s study (2008), a new database with 84 countries during 1980-2004 supported that tight regulations on unconventional bank activities can eliminate the harmful effect on bank development.

However, there are also plenty of literatures arguing the drawbacks of tight bank regulations. Using bank-level data for 80 countries in the years 1988-95, Demirguc,-Kunt and Huizinga (1999) found that foreign banks usually have higher net interest margins and profits than domestic banks in developing countries. And the fraction of entry denied in those countries like Egypt, Kenya and Thailand is above 75 per cent (Demirguc-Kunt et al, 2004). Regulations prevent foreign well-performed banks from entering domestic market, and domestic banks lose the opportunities to get progressed, which is harmful for competition and market efficiency. Similarly, Barth, Caprio and Levine (1997, 2003, 2008) find out there is a negative link between restrictions on bank entry and bank efficiency, it indicates that barriers to foreign-bank participation enhance bank fragility. As indicated by Barth et al. (2003), bank activities restrictions are negative for bank performance and stability, with contrast to diversification of activities through which banks are able to diversify income sources and enhance stability. Moreover, they also pointed out the regulatory reform of banks which has been conducted over 10 years all over the world didn’t make progress as expected. In addition, there is evidence that the corporate tax burden is fully passed onto bank customers, while higher reserve requirements are not, especially in developing countries (Demirguc,-Kunt and Huizinga, 1999). Furthermore, as a key component of bank regulations, deposit insurance is regarded as adversely relate to net interest margins and profitability. After observing data from OECD since 1985 to 1990, Bartholdy, Boyle, and Stover (1997) stated that a 25-point decline in deposit interest rate occurred due to the explicit deposit insurance. It is hold by Barth, Caprio and Levine (2003) that generous deposit insurance schemes are very strongly and negatively linked with bank stability.

§3.2 Institutional Environment

While analyze the impacts of bank regulatory restrictions on cost of financial intermediations, it is noted by Demirguc,-Kunt et al. (2004) , bank regulations cannot examined in isolation since they reflect to a high extent to private property and competition. Financial intermediations is often considered containing several fiduciary problems resulting from asymmetric information, adverse selection, and agency costs which causally related to an unperfected contract system (Allen and Santomero, 1998; Hart, 2001; Aggarwal and Goodell, 2009). Financial institution is one of the mechanisms expected to resolve those problems. Financial institution, according to Fligstein (2001), is the result of evolvement of governance, property rights, and control rules of exchange for markets. To consider the overall institutional environment, two indicators can be conducted: property rights protection and economic freedom (extent that banks feel free to conduct business).

A broad set of literature shows that financial institutions have negative influences on net interest margins and can promote more competitions in the financial markets (Engerman and Sokoloff, 1997; Acemoglu, Johnson and Robinson, 2001; Easterly and Levine, 2003; Demirguc-Kunt et al., 2004). Moreover, according to Lensink, Meesters and Naaborg (2008), foreign banks on average are less efficient compared with domestic ones. And a better financial institution environment can help to mitigate such inefficiency. Redrado (2007) states that financial institutions are considered to diversify bank risks throughout transforming into massive financial supermarkets that provide services associated with commercial banks, investment banks and asset management. In addition, Claeys and Vennet (2003) find that well-performed institutional environment enable banks to maintain the confidence of depositors even if their capital requirement is lower. Observing data from 57 countries during 1997-99, Breuer (2006) find that the overall institutional environment can reduce the amount of problem loans by easing banks’ internal interest conflicts. Besides lower net interest margins, Strahan (2004) points out that better institutions can also lower the overhead expenditures of banks and help contribute to a more efficiency and lower-cost banking system.

Alternatively, Aggarwal and Goodell (2009) argue that define property rights and costs of enforcing contracts—including costs of acquiring and processing relevant information—are involved in transaction costs, and will increase bank’s overhead expenditures. Moreover, the property rights protection can be considered as protecting prior-succeed entities and increase the barriers of new-comers. Thus, it may cause unbalance development and inefficiency in banking market (Demirguc,-Kunt and Huizinga, 1999; Barth, Caprio and Levine, 1997, 2003). As mentioned before, to some extent net interest margins can be regarded as the income of bank (Dewatripont and Tirole, 1994), financial institutions may lead to decline or even losses for banks by lower net interest margins. However, according to Bianco, Japelli and Pagano (2001), the overall impact of institutions on net interest rate margins is theoretically ambiguous. On the one hand, improvements in the institutional environment are able to increase the value of collateral for bank loans. Hence it benefits existing borrowers for reducing the cost of financial intermediation. On the other hand, such improvements lead low-grade borrowers suffering higher interest rate for bank loans, by increasing the extension of the credit market.

§3.3 Banking market structure

Bank concentration is measured as proxy the proportion of assets for the group (ie, 3) of largest banks in the banking market. In early decades, researchers have found that bank concentration has a positive relationship with bank net interest margins, and can increase the efficiency of banking market (Graddy and Kyle, 1979; Smirlock, 1985). In highly concentrated banking market, despite of overhead expenditures, powerful banks tend to gain more profit through setting high interest rate for bank loans and lower deposit interest rate. (Berger and Hannan, 1989; Neumark and Sharpe, 1992). Likewise, Demirguc-Kunt and Huizinga (1999) find that banks with larger market share in high concentration outperform those have more rivals and enable to enjoy higher interest margins. In contrast, some argue that concentration is deleterious for bank system since concentration lead to less efficiency and lower interest margins (Cetorelli and Gambera, 2001; Beck et al., 2006). Berger et al (1998) later find that banks in lower concentrated market more likely to outperform those in higher concentration.

Results of studies in recent years have been significantly enhanced. An underlying factor of bank concentration sector is important to be aware of is that: the impacts of concentration on the cost of intermediation are mixed and depend on national political economy variables, such as regulatory restrictions, institutional environment, macroeconomic factors, competitions and bank-specific characteristics, etc.(Demirguc-Kunt et al., 2004;). By observing data across 72 countries and over 1400 banks, Demirguc-Kunt et al. (2004) find there are three possible outcomes about the impact of bank concentration to net interest margins:

Bank concentration has a significant positive relationship with net interest margins when controlling for bank-specific factors. But such relationship will be subverted if controlling for regulatory impediments to competition and inflation instead.

Bank concentration tends to still have a positive impact (and never goes negative) on interest margins when controlling for macroeconomic environment and regulatory restrictions. However, this impact is not significant since concentration is regarded as the signal of competition in the banking market.

While controlling for regulatory restrictions and institutional environment, there is no positive relationship existing, although that is predicted by some theories.

Similarly, González (2009) concludes that, tighter restrictions on bank activities, bank freedom and reserve requirements increase the positive influence of bank efficiency on market share and market concentration. However, higher fraction of entry denied diminishes such impact. In addition, Beck et al. (2006) state that financial crisis has lower probability to happen in countries with higher bank concentration, even after controlling for differences in commercial bank regulatory policies, national institutions affecting competition, macroeconomic conditions, and shocks to the economy.

§3.4 Other factors

Besides the three key determinants mentioned before as regulatory restrictions, institutional environment and market structure, inflation also plays a quite important role in analysis cost of financial intermediations. Study by Boyd, Levine and Smith (2001) indicates that financial system and banking market are less developed in nations of high inflation rate. Huybens and Smith (1999) point out that inflation can exacerbate the degree of information asymmetry and increase interest margins as a result. Similarly, Demirguc-Kunt et al. (2004) find that inflation has a positive relationship with interest margins when controlling for macroeconomic and financial sectors. In addition, rather than foreign ownership banks, state ownership of banks can influence the pricing of loans and deposits, hence its degree is positively linked with net interest margins. Moreover, state ownership of banks tends to occur in countries with substantial corruption and poor long-run growth performance (Park and Sehrt, 2001; LaPorta, Lopez-de-Silanes and Shleifer, 2002), and entry regulations generally tend to be most prevalent in countries with corrupt political institutions (Djankov et al. 2002).

Section 4. Conclusion

To sum up, in order to boost economic growth, financial efficiency is considered as much more important, in particular the cost of financial intermediations. A broad set of studies conclude three key determinants of bank efficiency, considered in terms of net interest margins and overhead expenditures. Regulation is regarded as the most crucial one and it reflects broad, national approaches to property ownership and competitions. It is suggested that tighter financial regulations will boost the cost of financial intermediations. Overall institutional environment, although some arguments existing, is most commonly believed having a positive relationship with net interest margins and therefore the bank profits. Situations with market structure are mixed since it depends a lot on national political economy variables (such as regulatory restrictions, institutional environment, macroeconomic factors etc.), and also considered as the signal of competition and inflation. These three factors cannot be analyzed in isolation because there are significant closed correlations among variables. Moreover, inflation and bank ownership also contribute to the cost of financial intermediations.

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