The Market Structure And Financial Development Finance Essay


Banking industry comprises an important part of financial system. Its market structure has an impact on its performances as well as the whole system. To analyse the relationship between banking market structure and financial development/financial stability, we use information of finance of different countries from 2003 to 2009 in the financial database (world bank).

Analysis of the relationship between the market structure and financial development

The model

The deposit money bank asset/GDP (dbagdp) is a measure of financial depths in banking sector, which reflect financial development. Concentration is the assets of three largest banks as a share of assets of all commercial banks as a measure of market structure. We also include other independent variables such as inflation GDP deflator and M2/GDP. M2/GDP indicates the liquidity of financial institutions.

As the estimated regression model above illustrated that coefficient between dbagdp and concentration is equal to 0.128 and statistically significant, and coefficient between inflation and dbagdp is negative and significant, equal to -0.010. The coefficient between M2/GDP and dbagdp is relatively small 0.005 but strongly statistically significant. We also noticed that R square is 0.54, indicating a strong explanatory power of the equation.

The stock market capitalization/GDP (stmktcap) is a measure of financial depth in capital market. To analysis the relationship between capital market development and market structure, we have found a positive and significant coefficient of 0.616. And the coefficient between M2/GDP and stmktcap is also positive and statistically significant, which equal to -0.004. However, there is an insignificant relationship between inflation and stmktcap as p-value is over 0.05. We also noticed that R square is 0.33, indicating a relatively strong explanatory power of the equation.

Theoretical review

This results support the market power theory and efficiency theory as many literature studies have found positive relationship between bank performance and market structure. The high concentration in financial industry is encouraging financial development. From banking industry’s unique perspective, banks with big market shares may exert market power to charge higher loan rate but pay lower deposit rate thus earning profits higher than would be the case in a less concentrated market structure.

The high concentration, which also means reducing numbers of banks in financial industry, will increase bank charter value and future expected profits. Meanwhile more funds from depositors would be directed to those sound banks. The funds could be used to invest in other profitable projects in financial markets, promoting financial developments.

In addition, concentrated market structure indicates that banks could take advantage of new technology and superior management resources to achieve economics of scale, therefore lower the costs and earn higher profits. The efficiency hypothesis clarify the profits-concentration relationship, banks of large size are more efficient than banks of small size because then follow best cost practice. (Berger, 1995)

The high concentration tends to give rise to collusion and monopoly power. Because when large banks collude, even become oligopoly in the financial market gaining the power to set the price higher than competitive markets, they are able to earn higher profits.

2. Analysis of the relationship between the market structure and financial stability

The model

According to the concentration-stability hypothesis, concentration contributes to stability. In the model, financial stability is the dependent variable which could be seen through the banking risks, bank zscore. For a stable financial system, the banking industry is able to manage its risks and run in a safe and sound way to avoid panic. As for the independent variables, except for the concentration ratio to illustrate the market structure, other variable are also included in the model. Firstly, banking crisis is associated with financial liberalization and loose monetary policy which could be reflected by money growth rate. Secondly, profitability could provide a cushion to shocks (Hellmann, Murdoch, and Stiglitz, 2000), consequently ROA is included. Meanwhile, the amount of leverage has important effects on bankers’ behavior, for example moral hazard, for another, capital could reduce the risk of failure.

This model because of limited information has an R-square of 0.0339. Additionally, the relationship between these independent variables is insignificant. Under the 95% confidence level, concentration is positively related to bank zscore significantly which means high concentrated market results in stability. The coefficient is 6.48 meaning that 1 percent increase in the concentration would generate 6.48 percent reduction in bank risks. While for other independent variables, it seems that there are no significant statistical relationship between them and financial stability.

Non-performing loans is also an indicator for banking stability. Variables like concentration, net interest margin and money growth rate are used to explain that. It shows that firstly higher concentration results in less non-performing loans, which is in line with the first model. While higher margin could increase instability significantly as the data is from 2003 to 2009 when there is an economic bubble where banks expand lending regardless of the credit of borrowers, thus leading to an increasing amount of problem loans. Similarly, the money growth rate has no significant relationship with the banks’ stability.

Theoretical review

The test results support the "concentration-stability" view arguing that compared with a competitive banking system, concentration would result in more stability. Firstly, concentrated banking systems could generate a higher charter value. Keeley (1990) argues that this value would decrease bank manager’s incentives to take excessive risks. As higher charter value would lead to larger opportunity costs if banks tend to fail. In order to protect future profits, bank managers therefore would not take risky investments.

Furthermore, according to Allen and Gale (2000), in the perfect competition banking system, other banks are not willing to provide liquidity to a troubled bank which is faced with a temporary liquidity shortage. Consequently, this troubled bank tends to fail which would generate negative influences on the whole banking sector. On the contrary, Saez and Shi (2004) show that in a concentrated banking system, the number of banks is limited, thus these banks can cooperate each other better, and help a troubled bank to solve the temporary liquidity issues.

In addition, some individuals including Williamson (1986), Boyd and Prescott (1986), Allen (1990) predict economies of scale in intermediation. They argue that larger banks in a concentrated banking system could reduce their risks by diversifying portfolios. Increased profits caused by concentration also provide a shield from adverse shocks.

Moreover, a concentrated banking system with smaller number of banks is easy to monitor, meanwhile the risk of contagion also decreases, thus lowers the probability of systemic crisis and banking system fragility. According to Allen and Gale (2000), a history in the US has proved this point. The US possessed larger number of banks than the UK or Canada, and such a banking structure resulted in greater financial instability.


Based on the statistical model analyze, financial developments are promoted under concentrated banking markets.

The test also proves the concentration-stability view from the perspective of lowering bank risks and reducing the amount of non-performing loans.