Banking competition and efficiency: A micro-data analysis on the Czech banking industry

Abstract

As banks play a fundamental role in the financing of the economy, banking competition exerts an impact on economic development. However, there are some potential negative effects of banking competition through excessive risk-taking by banks, which may hamper financial stability (Allen and Gale, 2004; Carletti and Hartmann, 2002). Moreover, a higher degree of competition in banking markets is expected to provide welfare gains by reducing the prices of financial services and thereby accelerating investment and growth. These gains should in fact come from two channels of transmission. On the one hand, a higher degree of banking competition should result in lower monopoly power of banks, and therefore a decrease in banking prices. On the other hand, heightened competition should encourage banks to reduce their costs, that is, their cost inefficiencies. This latter channel is particularly promising in terms of welfare gains, as the order of magnitude of the cost inefficiencies in the banking sectors of European transition countries has been shown to average between 30% and 50% (eg Hasan and Merton, 2003; Fries and Taci, 2005). The issues regarding banking competition and its effects are therefore of particular interest in transition countries, as bank credit there is by far the largest source of external finance for companies (Caviglia et al., 2002). Since investment is particularly sensitive to a decrease in loan rates, a reduction of monopoly rents and cost inefficiencies would consequently impact investment and economic growth.