The elusive effect of bank size on profits

Abstract

This study investigates the determinants of bank profit while paying particular attention to the influence of market share on profit, referred as the market share effect. The research seeks to answer the question whether the market share effect is conditional upon four country institutional factors including concentration ratio, bank regulations, the government's governance and country wealth, and is thus better in explaining the mixed results in the literature. This study employs comprehensive data of 44 countries from 1998 to 2004. The results show that market share positively influences profit when no country institutional factors are considered, but further strengthened in countries that are characterized by high concentration ratios, high restrictions on bank activities in insurance and real estate, good investor protection and a strong rule of law.

Keywords:

• market share
• bank profit
• market structure
• government governance

Notes

Based on interviews with bankers, they report that ‘Interviewees all agreed that the motives for consolidation are affected by the size of the financial institutions involved’.

For more information on Taiwan's second phase of financial reform, readers are referred to http://www.taipeitimes.com/News/taiwan/archives/2007/05/24/2003362231

The terms ‘large market shares’ and ‘large banks’ are used interchangeably throughout this paper. We recognize that the two underlying concepts are not completely the same. A bank with large market share is usually a large bank but a large bank does not necessarily have a large market share. For example, when a country has many banks, a large bank may not have a large share, such as in the case of the USA. We will notice it whenever there is confusion.

It cannot be overlooked that conflicting results providing evidence that smaller market share or middle-size banks which have better profits have also been reported. Employing UK banks as their sample, Kosmidou, Pasiouras, Doumpos and Zopounidis (2003) find that smaller banks have economies of scale (EOS) and superior profits. Vennet (2002) found that, unlike large banks with assets greater than 1000 billion euros, European banks with assets of less than 10 billion euros show evidence of EOS.

The concept is close to the threshold model in that the influence of market share is different when an exogenous variable is above or below a threshold.

For example, Demirgüç-Kunt and Huizinga (1999) employ the interaction between the profit determinants and the country's GDP per capita as their conditional repressor to check whether some of these determinants affect banking differently in developing and developed countries.

Because economic conditions are exogenous, there is no endogeneity problem and the changing influence of market shares is still independent of the dependent variables. We thank the referee to point this out.

Smirlock (1985) used the interaction terms of market share and concentration ratio to indirectly test whether the finding – market concentration has no effect on bank profitability once market share is properly considered – is due to a potential relationship between market share and monopoly rent-sharing.

Beck, Demirgüç-Kunt and Maksimovic (2005) find that firms that operate in underdeveloped systems with higher levels of corruption are affected by all types of hindrance to a greater extent than firms operating in countries with less corruption.

The high-income countries comprise Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Korea, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the USA; the upper middle-income countries are Argentina, Chile, Malaysia, Mexico, South Africa, Taiwan, Turkey and Uruguay; the lower middle-income countries include Brazil, Colombia, Egypt, Peru, the Philippines, Sri Lanka and Thailand; and the low-income countries are India, Kenya, Nigeria and Pakistan.