Asian Research Thesis Index

Abstract

This dissertation analyzes the level of competition in the banking sector of Pakistan in the context of massive transformation in its structure and business activities since the implementation of financial sector reforms. The study employed a four-pronged empirical strategy along with bank level annual data from the year 1996 to 2015 to account for the multi-dimensional nature of banking competition. Relying on traditional measures of the market structure, five indicators of market concentration (number of banks, concentration ratio, comprehensive concentration index, Herfindahl-Hirschman index (HHI), and the HallTideman index) are used to analyze the changes in the market structure in the context of structure-conduct-performance (SCP) paradigm. The results indicate that the market structure of banking industry in Pakistan has significantly changed in favor of competitive environment. As changes in the market structure indicators can also be interpreted in the context of efficient structure (ES) paradigm, this dissertation explicitly evaluated the relevance of both SCP and ES paradigms by estimating a reduced-form profit function. The formal tests of hypotheses do not provide meaningful support to SCP paradigm. The ES paradigm is more relevant in case of Pakistan as the cost efficiency plays a statistically significant role in determining profitability of banks. These results suggest that market structure indicators cannot be unambiguously used for exploring competition in banking sector of Pakistan. In the next step, the study focused on the formal tests of competition. One of the widely used Panzar-Rosse H-statistic is estimated by using panel data to measure the degree of competition in banking sector. The results suggest that banking sector of Pakistan exhibits the characteristics of monopolistic and perfectly competitive market structures. The relevance of monopoly structure is out rightly rejected across different specifications of the model. The validity of these findings is also supported by an explicit test of crucial assumption of equilibrium condition, and the analysis of pass-through from the policy rate to banks’ retail rates. The final assessment of competition among banks over time in this study is carried out by using the newly developed Boone indicator. A translog cost function is estimated by using bank level panel data and method of maximum likelihood to derive marginal cost for each bank, which is subsequently used to estimate the value of Boone indictor. The results show that Pakistan has a competitive banking sector as banks with higher marginal cost (inefficient banks) are losing their market share to banks with lower marginal cost (efficient banks). Moreover, the rolling (and year-wise) estimates of Boone indicator suggest that the level of competition among banks has gradually increased with passage of time. This dissertation provides strong evidence in favor of increasing competition in the banking sector of Pakistan. Detailed results suggest that the policy focus should be on promoting efficiency in the banking sector as: (a) there are more than enough number of banks in the industry to compete among themselves; and (b) traditional indicators of the market structure reflect a favorable environment for healthy competition in banking sector of Pakistan.

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