Empirical evaluation of ‘structure-conduct-performance’ and ‘efficient-structure’ paradigms in banking sector of Pakistan

ABSTRACT

Historically, the banking sector of Pakistan has been characterized by credit ceilings, directed and subsidized credit, controlled interest rates and lacking competition. This scenario prevailed till the financial sector reforms in 1990. However, after 1990, the banking sector changed significantly and the reforms led to notable improvement in the indicators of market structure of the banking industry of the country. In literature, the changes in indicators of market structure are interpreted in the context of either structure-conduct-performance (SCP) or relative market power (RMP) paradigm, and/or in relation to the efficient structure (ES) hypothesis. This paper studies relevance of SCP, RMP and ES paradigms for banking industry of Pakistan. This study uses (balanced) panel data, spanning 1996 to 2015, of 24 commercial banks to estimate banks’ profit function by using fixed effects model. Findings suggest that: (a) there is a weak association between the indicators of market structure and banks’ performance; (b) there is no empirical evidence to support SCP or RMP paradigms; and (c) the ES paradigm is relevant in the case of banking sector of Pakistan. Thus, the focus of policymakers should be to improve the efficiency of the banking sector in Pakistan. Focus on improving indicators of market structure, like concentration ratios, to encourage competition in the banking sector may not be productive.

KEYWORDS:

• Structure-conduct-performance
• efficient-structure
• competition
• banking sector

JEL CLASSIFICATION:

• Codes: D40
• E50

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. While there is no consensus on the number of banks to include for calculating the concentration ratio, in Pakistan the banking sector has been dominated by 5 banks since the nationalization in the early 1970s. It is, therefore, instructive to calculate the concentration ratio for the big 5 banks: National Bank of Pakistan, Habib Bank Limited, United Bank Limited, MCB Bank Limited, and Allied Bank Limited.

2. Selection of time period is based on the availability of consistent data set on the subject.

3. Three specialized banks owned by the public sector are not included, as these primarily rely on equity or borrowing (instead of deposits) for their lending activities. Moreover, government policies heavily influence their business activities in contrast to the developments taking place in the banking system.

4. These banks include 4 public sector commercial banks, 4 foreign banks, and 16 private commercial banks. None of the Islamic banks are included in the profit function estimation as the estimation period starts before their arrival. Indirectly, all the banks operating in Pakistan are taken into account for the calculation of the concentration ratio and HHI since ‘overall’ banking assets has been used in the denominator. Names of individual banks are reported in Annex 1 (Table A1).

5. Unlike ROA, the return on equity (ROE) indicates higher dispersion. It is understandable as banking is a highly leveraged business. Specifically, equity to assets ratio is less than 10 percent (in Pakistan) over the estimation period.

6. 92.1 percent of ROA data are ± 5.0 percent. In case of ROE, only 7.5 percent of observations are −25 percent or lower.

7. As of 31 December 2015, total assets of the biggest bank were 666 times the total assets of the smallest bank, implying residual variance of these banks would be substantially different, making it necessary to account for heteroskedasticity by using residual variance of each bank as weight.