Competition, ownership and bank performance in transition

Transcription

1 Competition, ownership and bank performance in transition by Steven Fries,* Damien Neven** and Pau Seabright*** August 2004 Abstract This paper examines how competition among banks and their ownership infuence the margins and costs of banks in the post-communist transition. To aow the parameters of the margin and cost functions to change over time, we divide the entire sampe period in haf (1995 to 1998 and 1999 to 2001). In the earier period, we find that privatised banks earned higher margins than newy estabished banks or state-owned banks, whie newy estabished foreign banks had significanty ower margina costs. In the ater period, the differences in margins and costs among private banks were no ong significant, but state-owned banks earned significanty ower margins. These findings suggest that initiay the privatisation of state-owned banks was associated with greater demand for ending and deposit taking services and the entry of new foreign banks with ower costs. However, these effects did not endure and private banks became more simiar over time. At the same time, the performance of remaining state-owned bank weakened. JEL codes: G2, L1, L8, P2 Keywords: banking, imperfect competition, cost functions, transition. * Corresponding author, European Bank for Reconstruction and Deveopment, One Exchange Square, London EC2A 2 JN, United Kingdom, emai: friess@ebrd.com. ** Graduate Institute of Internationa Studies, University of Geneva, and CEPR. *** Université de Tououse I and CEPR. We thank Nadia Aeshina for vauabe research assistance and Erik Bergöf, Wendy Carin, Christa Hainz, Mark Schaffer Caudia Senik-Leygonie and Anita Taci for hepfu comments and suggestions. The funding of the Japan-Europe Cooperation Fund is gratefuy acknowedged. The usua discaimer appies.

2 1. Introduction Since its start in 1989, the post-communist transition has transformed fundamentay Eastern European banking systems. Under the command economy, state authorities directed credit aocation with scant regard for capacity to repay, using state banks to channe funds to state (or sociay) owned enterprises for inputs and investments authorised under panning. To direct resources in this way, banks speciaised by economic sectors (or foreign trade), rather than diversified across them. State savings banks speciaised in coecting deposits from househods, athough most savings was forced and done by the state. The payment system consisted of a cash circuit for househods and commercia transfers among enterprises handed by the centra bank. At the same time, without a profit incentive, state banks were not encouraged to compete for oans and deposits or to contro costs. Because of this structure of sociaist banking systems, and with the start of transition towards a market economy, banks had to restructure fundamentay their outputs and use of inputs. Governments and centra banks in Eastern Europe have impemented severa types of poicies aimed at transforming sociaist banking systems into market-oriented ones (see, for exampe, Anderson, Bergöf and Mizsei, 1996, EBRD, 1998, and Bergöf and Boton, 2002). Banking systems were iberaised by freeing interest rates and decentraised by transferring commercia banking activities from the centra bank to state banks. State banks were restructured and privatised and new private banks, both domestic and foreign, were aowed to enter the markets. Moreover, to support arms-ength ending reationships between banks and their borrowers and to foster confidence of depositors in banks, ega frameworks were overhaued (incuding the - 2 -

3 strengthening of creditor rights) and systems of prudentia reguation and supervision were initiated. In broad terms, the main poicy instruments to promote the transformation of banking were therefore iberaisation, privatisation, competition and fundamenta institutiona change. To understand this process of change in post-communist countries, we examine the associations between competition among banks and their ownership on the one hand and their behaviour and performance on the other. To do so, we mode and investigate empiricay the structure of margins on oans and deposits and the costs of providing these services. Given the starting point of transition, attracting demand for oans and deposits and controing their costs are centra to the process of deveoping market-oriented banks. This requires effective competition among banks, as we as the incentive of profitabiity and the constraint of effective prudentia reguation. In this paper, we deveop a mode of monopoistic competition in banking and use it to investigate the equiibrium structure of margins earned on oans and deposits. This mode enabes us to identify the associations among the extent of competition in banking, the origin and ownership of banks, and their margins. The origin and ownership variabe is used as a proxy measure for the incentive and capacity of a bank to attract demand for its oans and deposits and to contro its costs. The mode aso aows us to test directy for the intensity of competition associated with the number of banks in a market and indirecty for product differentiation among banks. This approach buids on the extensive empirica studies of competition in banking in industriaised economies beginning with Shaffer (1982). 1 Recent studies by Geos and Rodós (2002), Yidirim and Phiippatos (2002b) and Drakos and 1 This iterature incudes severa recent studies by Bikkar and Groeneved (2000), De Bandt and Davis - 3 -

4 Konstantinou (2003) extend this iterature to deveoping countries and transition economies. The studies of competition in banking find that systems are often characterised by imperfect competition. In a word-wide study of the factors that infuence the extent of competition in banking, Caessens and Laeven (2003) shows that banking systems with greater foreign entry and fewer activity restrictions tend to be more competitive. Theoretica anayses of banking in transition economies, moreover, emphasise the important ink between competition and institutiona deveopment in banking. In a mode of coateraised ending by oigopoistic banks, Hainz (2003a) shows that, if creditor rights are weaky protected, banks have more market power other factors being equa and are abe to extract more rents from their borrowers, thereby hoding back the scae of intermediation. Hainz (2003b) aso demonstrates that in mode of spatia competition among banks the intensity of competition depends not ony on the number of banks (that is, the average distance between them), but aso on the extent and effectiveness of creditor rights. A key feature of both modes is that a better institutiona framework (that is, the more effective protection of creditor rights) strengthens competitive pressures among banks. In addition to the anaysis of bank revenues, we estimate a standard trans-og cost function. The estimated parameters of the cost function together with the underying data on costs, deposits and oans enabe us to cacuate the margina costs of deposit taking and ending by bank origin and ownership. This provides a basis for examining variations in margins and margina costs across bank types and over time. To impement empiricay our mode of monopoistic competition in banking and to investigate the structure of bank costs, we use a pane dataset consisting of 270 (2000) and Bikkar and Haaf (2002). The references in these papers provide a more extensive guide to this iterature

5 banks in 15 East European countries (Bugaria, Croatia, the Czech Repubic, Estonia, FYR Macedonia, Hungary, Kazakhstan, Latvia, Lithuania, Poand, Romania, Russia, the Sovak Repubic, Sovenia and Ukraine) and covering the years 1995 to Fries and Taci (2004) deveoped the data set, which is unique in its coverage of timevarying bank ownership in transition economies. Their reated study examines the reative cost efficiency of banks (that is, their reative productivity). The empirica estimations of our monopoistic competition mode of bank revenues and of the cost function aow for structura changes between two subperiods that divide the entire sampe approximatey in haf. They yied a number of interesting resuts regarding the performance of banks by their origin and ownership. In the earier sub-period, the average margins on oans and deposits earned by privatised banks are significanty higher than those of newy estabished banks or state-owned banks. In the ater sub-period, the differences in margins among private banks decines, but the margins of a types of private banks are significanty above those of state-owned banks. This pattern in margins suggests that privatised banks initiay had either an advantage in attracting demand for their oans and deposits (for exampe, due to service improvements and estabished reputations) or a cost disadvantage in providing oans and deposits. The evidence on costs points primariy to the former interpretation. Evidence from the estimated cost equation indicates that ony newy estabished foreign banks had significanty ower margina costs than other types of banks in the earier sub-period. Moreover, there are no significant differences in margina costs among the five types of banks in the second sub-period. The evidence on margina costs by bank origin and ownership is therefore consistent with that on margins. Newy foreign estabished banks appear to have fostered competition - 5 -

6 through ower margina costs, whie privatised banks appear to have done so by attracting more customers, possiby through improvements to ending and deposit taking services and their estabished reputations. In comparison with private banks, state-owned banks operated in both subperiods with margins that were ow reative to their estimated margina costs. The ow margins of state-owned banks may refect the absence of a profit motive for such banks and the ack of capabiities to attract demand for their services. At the same time, the reativey poor performance of state-owned banks has necessariy not forced them to exit from the market. The anaysis of bank margins, moreover, indicates that competitive pressures among banks increased with the number of banks in the market. The anaysis of bank margins is aso consistent with the hypothesis that the oan and deposits markets are monopoisticay competitive, a basic assumption of our mode. 2. Literature on competition, profitabiity and costs of banks in transition The existing empirica iterature on transition banking that is cosey reated to this study consists of three strands. The first examines the extent of competition in these banking markets. The second strand studies the reative profit and cost efficiency of banks within transition economies. The third considers factors that infuence net interest margins in transition banking. In the first strand, Geos and Rodós (2002), Yidirim and Phiippatos (2002b) and Drakos and Konstantinou (2003) use the methodoogy of Panzar and Rosse (1987) to assess the competitive conditions in transition banking. The Panzar-Rosse H-statistic measures the percentage change in a bank s equiibrium revenues associated with a one per cent change in a the bank s input prices. This statistic can - 6 -

7 be used to infer the competitive structure of the industry in which the bank operates. An H-statistic vaue of one is associated with perfect competition and a vaue of zero or ess with monopoy or perfect cousion. Vaues in the range between zero and one characterise cases of monopoistic competition. The Geos and Rodós study covers three transition economies (the Czech Repubic, Hungary and Poand, as we as five Latin American countries) and the period 1994 to For the transition economies, the estimated vaues of the H- statistics ie between the vaues of one (perfect competition) and zero (monopoy); athough, in the case of Hungary the H-statistic is sufficienty cose to one that the hypothesis of perfect competition cannot be rejected. Moreover, this study finds that the competitive conditions remain broady stabe between two sub-periods, 1994 to 1996 and 1997 to The studies of Yidirim and Phiippatos and of Drakos and Konstantinou cover most of the transition economies covered in this paper. Their respective sampe periods are aso broady simiar. Both find that most banking markets in Eastern Europe are characterised by monopoistic competition. However, for FYR Macedonia and the Sovak Repubic, Yidirim and Phiippatos cannot reject the hypothesis that banks act as if they were monopoies or perfecty cousive oigopoies. Drakos and Konstantinou cannot reject this hypothesis in the case of Estonia and Latvia. Unike Geos and Rodós, Yidirim and Phiippatos aso find that the extent of competition in transition banking has increased over time. Studies of the reative profit and cost efficiency of banks within transition economies incude Grigorian and Manoe (2002), Yidirim and Phiippatos (2002a), Bonin, Hasan and Wachte (2004) and Fries and Taci (2004). Again, they cover most of countries covered by this study and their sampe periods are broady simiar. The - 7 -

8 efficiency measures and estimation methodoogies used in these studies vary. The studies of Fries and Taci and of Grigorian and Manoe examine cost efficiency using the stochastic frontier approach and data enveopment anaysis, respectivey. Yidirim and Phiippatos and Bonin, Hasan and Wachte use the stochastic frontier approach to anayse both cost and profit efficiency. Yidirim and Phiippatos aso empoy the distribution free approach. Each of these studies finds significant variation across countries in bank efficiency and Fries and Taci, Grigorian and Manoe, and Yidirim and Phiippatos seek to expain this variation by examining country-eve variabes as correates of bank efficiency or costs. Bonin, Hasan and Wachte, which focuses primariy on the effects of foreign ownership, simpy aow for fixed effects for both country and time. Grigorian and Manoe observe that bank cost efficiency is significanty and positivey associated with GDP per capita and weaky and positivey associated with a measure of progress in institutiona reform. Fries and Taci find no association between cost efficiency and GDP per capita, but a significant non-inear association between progress in institutiona reform and costs (decining eary in the process of banking reform and then increasing). Regarding the association with measures of market competition, the findings are mixed. Fries and Taci and Yidirim and Phiippatos find that greater competition in a banking market (measured by the share of foreign banks in tota assets and the Panzar-Rosse H-statistic, respectivey) is associated with greater cost efficiency. Yidirim and Phiippatos find that greater competition is negativey associated with profit efficiency, a finding consistent with competition reducing margins. In contrast, Grigorian and Manoe observe that higher banking market concentration is associated with great cost efficiency. The association between ownership and efficiency is broady consistent across - 8 -

9 the four studies. A find that banks with majority foreign ownership are more cost efficient than those with majority domestic ownership. However, Yidirim and Phiippatos and Bonin, Hasan and Wachte observe that majority foreign ownership of banks is not associated with greater profit efficiency. In addition, Fries and Taci find that private banks newy estabished after the start of transition (new estabished banks) are more cost efficient than state-owned banks and privatised banks with majority domestic ownership, but ess efficient that privatised banks with majority foreign ownership. However, Grigorian and Manoe observe no difference in the cost efficiency of newy estabished banks and that of od banks (privatised and state owned). In the third strand of existing empirica research on transition banking, Drakos (2003) examines the net interest margins of banks in eeven post-communist countries over period 1993 to This study finds that net interest margins decrease significanty over time and that bank ownership has a significant effect. In particuar, Drakos observes that state-owned banks set significanty ower net interest margins that do other banks. 3. A mode of monopoistic competition in banking In this section, we derive a mode of banking market equiibrium under monopoistic competition that is used to examine the structure of revenues earned by banks and their costs. A bank is regarded as muti-product firm that manages both its assets and iabiities, incuding ending and deposit taking. A bank can aso invest in non-oan assets, such as securities. At the same time, a bank faces the baance sheet constraint that tota assets must be equa to tota iabiities pus equity capita. To satisfy the baance sheet constraint, it has the opportunity of borrowing or ending in - 9 -

10 the inter-bank market. The profit of a bank therefore incudes the returns obtained from its ending activities and non-oan assets, the interest paid on its deposits, and the interest earned from or paid out on its net position in the inter-bank market, as we as the operating cost of undertaking its activities. Let D, L and N denote deposits, oans and non-oan financia assets of bank i in country j at time t, excuding its gross inter-bank positions. R is the inter-bank rate in country j at time t, whie d r, r and n r are respectivey the interest paid on deposits and the interest earned on oans and nonoan assets. The expression C ( D L, N, W ) is a set of factor prices. The profit of a bank,, refers to operating costs, where E is the equity capita of a bank. Π can accordingy be written as W Π = r L + r n N r d D ( D, L, N W ) R ( L + N D E ) C,, (1) where the expression ( L N D E ) + represents the net debtor position of the bank in the inter-bank market. With a view to empirica estimation, the profit function of a bank can be rewritten as Π = n d ( r R ) L + ( r R ) N ( R r ) D + R E ( D, L, N W ) C,, (2) In order to examine how a bank earns its profits, we consider separatey the revenues

11 and costs of the bank. Given equation (2), the revenues of a bank, REV, are simpy n d ( r R ) L + ( r R ) N ( R r ) D Rtt E REV = +. (3) Since revenues, oans, non-oan assets, deposits and equity are observabe, this equation can be estimated directy. If this were done for our sampe of banks, the coefficients on the oan, non-oan financia asset and deposit variabes woud be estimates of the average margins that the banks have earned on these activities. The coefficient for bank equity woud be an estimate of the inter-bank rate. We now assume that each bank sets the rates for its oans and deposits to determine the respective margins, but that the returns on non-oan financia assets and the inter-bank rate are exogenous to each bank, This assumption refects the empirica evidence that banking markets in most countries are characterised by monopoistic competition, incuding the post-communist countries in Eastern Europe (see Geos and Rodós, 2002, Yidirim and Phiippatos, 2002, and Drakos and Konstantinou, 2003). Accordingy, we aow for the oan and deposit margins charged by each bank and the amount of its oans and deposits to be determined jointy by the interaction between a bank s suppy curve and the demand that it faces. In other words, we focus on ending and deposit taking as the activities in which banks can potentiay exercise market power. Banks are assumed to be price takers in the market for non-oan assets, such as government securities, and in the inter-bank market. The estimated coefficients for oans and deposits in the revenue equation can therefore be seen as equiibrium margins and variation in these equiibrium margins across banks and countries and over time can be further expored. In particuar, the

12 effects of exogenous variabes on equiibrium margins can be identified by specifying an equiibrium margin function. In what foows, we specify a mode of monopoistic competition among banks, derive equiibrium margins as a function of the underying parameters of the mode and examine the comparative static properties of the equiibrium margins. It is important to emphasis that this estimation aows for neither the direct identification of market power nor the estimation of suppy functions. This woud require the estimation of a structura mode where demand and suppy functions are jointy estimated, using observed margins and quantities (see Bresnahan, 1989, for an exposition of this approach and Neven and Röer, 1999, for appications to banking). This cannot be done in this paper because we do not have data on oan and deposit margins. Nevertheess, the structure of the equiibrium margins may give some indirect insight into the nature of competition in transition banking. 2 Consider now the oan market (the anaysis can be appied in the same way to the deposit market). Assume that a bank takes the inter-bank rate and the rate on nonoan assets as given and that its oan poicy is independent of its strategy with respect to deposits. This wi be the case if the cost function is separabe in oans and deposits. Assume that its margina operating costs with respect to oans is constant (a inear margina cost coud aso be accommodated). The profit of the bank in the oan market is then given by ( M c ) L Π =, (4) where M r R is the bank s margin in the oan market and c is the margina

13 cost of making a oan. 3 Assume further that each bank faces an inverse demand function of the type M = a L λ L, (5) ijc where L denotes the tota voume of oans sod by a other banks in the same country and time period and where 0 λ < 1. < This demand specification is adapted from Shubik and Levitan (1980) and aows for product differentiation. A bank may be abe to differentiate its oans in such a way that the demand curve is shifted out and the intercept a increases. The specification aso aows for reduced substitution between a bank s oans and those of its competitors in the market (that is, λ fas). Such reduced substitution can be associated with product differentiation (for exampe, through advertising) or market segmentation (for exampe, because of geographica distance among competitors). The characteristics of each bank s oans that determine such differentiation cannot be observed directy. Faced with this demand specification, each bank wi maximise profit by soving the foowing first order condition a 2 L λ L c = 0. (6) Summing up the first-order conditions for a banks in country j at time t yieds 2 This approach is therefore semi-structura and simiar in this respect to Panzar and Rosse (1987). 3 The mode can accommodate margina costs that are in genera a inear function of the amount of oans

14 ( c ) 2 L ( n 1) L = 0 a λ, (7) where ( c ) ( a c ) a, i country j at time t and L is tota oans provided by the banking system in n is the number of banks in the country at that time. The voume of tota oans in equiibrium is therefore given by L * = a 2 + λ c ( n 1). (8) Combining equation (8) with the first order condition for each bank yieds as the equiibrium amount of oans made by bank i in country j at time t L = ( a c ) λ ( a c ) 2 λ ( 2 λ )[ 2 + λ ( n 1) ]. (9) From equations (5) and (9) a bank s equiibrium oan margin can therefore be expressed as M = a ( 1 λ )( a c ) ( 2 λ ) λ ( a c ) ( 2 λ )[ 2 + λ ( n 1) ]. (10) parameters, The comparative static properties of the mode with respect to the fundamenta a, c and n,are straightforward to cacuate. For the equiibrium oan

15 M M margins it is possibe to show that > 0, > 0 a c M and < 0. In other n words, a bank s equiibrium oan margin increases with its abiity to increase the demand for its oans and with its inabiity to contro the margina costs of oans and decreases with the number of competitors in the market. It can aso be shown that a bank s profits in a market equiibrium are increasing in its abiity to shift out its Π demand curve and to contro its costs; that is, > 0 a Π and < 0. A profit c maximising bank woud therefore seek to contro its margina cost and reduce its margins in order to boost its market share and profits. Such a bank woud aso aim to expand demand for its oans and its market share. It is in addition possibe to express the equiibrium oan margin as a function of the equiibrium oan market share, * L L, which is observabe but depends on the underying mode parameters. In this expression, it is straightforward to show that, provided λ < 1, the oan margin is an increasing function of the market share. Moreover, the strength of the association between oan market share and margin increases as the vaue of λ decreases. A positive correation between oan margin and market shares is therefore an indirect test that the oans provided by banks are imperfect substitutes. In the empirica impementation of the revenue mode, we use observabe variabes that may be correated with the underying structura parameters of the mode, since the parameters, a, c and λ, cannot be observed directy. In particuar, we use the origin and ownership of banks as a variabe that may be correated with the incentive and capabiity of banks to increase the demand for their

16 oans and to contro their costs, that is a and j at time t (reative to the country s popuation), c. The number of banks in a country N, is used as measures of market competition. In addition, we incude the market share of a bank in the oan market to test indirecty that λ < 1. We contro for other country eve factors using fixed effects for countries and time, incuding their interaction. For costs, we use a standard trans-og specification. In particuar, the cost function takes the form n C t n t s 0 + β s s n Qs, + χ m m nwm, s t s, t n Qs, n = α β Q t, n m t n 1 2 m n m, n nwm, nwn, + δ s m s, m n Qs, χ nw, (12) m where Q s, are output quantities (that is, the amounts of oans, non-oan financia assets and deposits) and W u, are input prices (wages and the cost of physica capita). In estimating equation (12), we impose constraints on symmetry, β = and s, t β t, s χ =, and, homogeneity in input prices, χ = m, n χ n, m n m m 1, and adding-up, n m n, n = χ n, m = δ m, s = m χ. m 0 n m In the empirica impementation of this cost function, we aow for estimated parameters to vary with bank origin and ownership to make possibe comparisons with the estimated revenue function, in which the equiibrium oan and deposit margins vary with this observabe characteristic of banks. This specification for the cost function enabes us to compare the margina costs of oans and deposit across different types of banks, one of the factors that may contribute to the variation in equiibrium margins. Again, we contro for country eve factors using fixed effects

17 for countries and time, incuding their interaction. 4. Empirica impementation In the empirica impementation of revenue equation, we express revenues in the genera form of equation (3) and assume that banks engage in monopoistic competition for oans and deposits. The returns earned on non-oan assets and the inter-bank interest rates are assumed to be exogenous to individua banks. The equation for bank revenues therefore takes the form REV d () Likt + M ( ) Dikt + ρ N + σe + ε = M.., (13) where ρ and σ are the average return that banks can earn on non-oan financia assets and the average inter-bank rate, respectivey. We write individua equiibrium oan and deposit margins as a function of the observabe characteristics of banks that may be correated with the underying parameters of the mode and measures of the intensity of competition in the banking market. Specificay, the equiibrium oan margin of bank i in country j at time t is q M = φ own, + ϕ S + γ N + ε φ, (14) p p p s f where own p is a vector of time-varying origin and ownership dummy variabes (privatised with majority foreign ownership, privatised with majority domestic ownership, newy estabished bank with majority domestic ownership, newy estabished bank with majority foreign ownership, and majority state owned), S is

18 the oan market share of bank i in country j at time t, and banks. The error term is assumed to have the usua properties. N is the tota number of This specification aows us to examine whether the comparative static properties of the equiibrium margins in monopoistic competition mode are consistent with the data. The anticipated association between the origin and ownership of banks and their margins depends on both the variation in margina costs across bank types and that of the capacity of banks to increase demand for their services. For exampe, newy estabished banks may have both ower margina costs and ess capacity to increase demand for their services than od banks. On the cost side, newy estabished banks woud have benefited from not having to restructure existing banking organisations, whie on the revenue side they may have faced the disadvantage of not having estabished reputations in the market. We woud in addition anticipate that margins are negativey correated with the measures of market competition and positivey associated with market shares. The same specification can be used for the equiibrium margins in the deposit market, simpy substituting the superscript d for. However, because the costs of deposit taking and ending are not separabe and because the amounts of oans and deposits by bank are highy correated, we examine the comparative static properties of the mode using a singe scae variabe equa to the combined vaue of oans and deposit rather then estimate separatey the structure of margins for both oans and deposits. In the estimation, the origin and ownership dummy variabes, number of banks (scaed by popuation) and market share (weighted average of the oan and deposit market shares) are interacted with the singe scae variabe. The estimated coefficients on these variabes show how the average margin on oans pus deposits varies across banks with different observabe characteristics and with the measure of

19 the intensity of competition in the banking market. The coefficients on the non-oan assets and the equity variabes are estimates of the average rates of return and the riskfree interest rate, respectivey. Given that we introduce disturbances on the margin equation, the overa error term takes the form + d ( L + D ) ε ε +. (15) To account for the induced heteroscedasticity of the errors, we estimate equation (14) using generaised east squares, and because of the presence of an error term in the coefficients on oans pus deposits, we instrument the scae variabe using its own agged vaue, the bank origin and ownership variabes, the proxy measures of banking market competition and the country and time fixed-effects. We aso instrument the average oan and deposit market share variabe since it is endogenous. A Durbin-Wu- Hausman test indicates that it is appropriate to instrument these variabes in the estimations reported beow. To estimate the revenue equation, we use the Batagi (1981) error-components two-stage east squares estimator (EC2SLS) (see Batagi, 1995, Chapter 7). Country and time fixed effects are used to contro for other country eve factors. We aso aow for bank-specific random effects in the estimations reported beow. A Hausman test ceary rejects a bank fixed-effects specification in favour of the EC2SLS estimation with random effects. In the empirica impementation of the trans-og cost function, we aow the estimated parameters of the cost function to vary with the origin and ownership of banks, but omit most of the higher order terms in the fina trans-og specification. In

20 preiminary estimations most of these terms were not statisticay significant. Consistent with the estimation of the revenue equation, we use as the output variabes the vaues of deposits and oans, as we as the vaue of non-oan financia assets. The two input prices are the average US doar wages in the financia sectors of the countries incuded in the sampe and the rea interest. The rea interest is the ex-post rea interest rate that prevaied in the country at the beginning of each year. As with the revenue equation, we use country and time fixed effects to contro for other country eve factors. The error term is assumed to have the usua properties. We estimate the revenue and cost equations whie aowing for bank specific effects and using both fixed and random effects specifications. As with the revenue equation, we report ony the random-effects specification because the Hausman test rejects the fixed-effects mode in favour of this specification. 5. Data sources and variabe descriptions The primary source of data on the banks baance sheets, income statements and ownership is the BankScope database produced by the Bureau van Dijk, which incudes data on 10,227 banks word-wide. The database is updated monthy and the atest issue of the BankScope database used in this study was May The BankScope data are suppemented with the data and information from annua reports of the banks and from EBRD staff research on bank ownership. The centra banks and the nationa statistica agencies of the countries provided aggregate data on their banking systems, incuding the tota oans and deposits and the tota number of banks in the banking systems. In our sampe, we incude a banks in the BankScope database for which at east three years of data are avaiabe between 1994 and In addition, where

21 banks report according to both oca accounting standards and internationa accounting standards for at east five years, we seect data in internationa accounting standard rather than nationa accounting standards for banks. This accounts for 57 per cent of the banks in the sampe. The sampe incudes 270 banks from 15 transition countries (see Tabe 1), 18 banks in Bugaria, 34 in Croatia, 23 in the Czech Repubic, four in Estonia, eight in FYR Macedonia, 23 in Hungary, nine in Kazakhstan, 17 in Latvia, 10 in Lithuania, 35 in Poand, 4 in Romania, 41 in Russia, 14 in the Sovak Repubic, 17 in Sovenia and 13 in Ukraine. A bank accounting data are in nomina terms in US doars converted at current exchange rates. The composition of banks in our sampe aso varies over the sampe period of 1995 to There are 81 banks for which data are avaiabe for the entire sampe, whie there are 189 banks that enter the sampe after 1994 and/or exit from the sampe before The additions to the sampe are not necessariy new market entrants, but rather successfu banks that are added to the BankScope scope database over time. Exits from the sampe are due primariy to either bank faiures or mergers with other banks. This method of seecting banks from the BankScope database introduces seection bias in the data, as does the seection by BankScope of banks to incude in the data set, which are primariy the arger and financiay sounder banks in the region. The estimation resuts are therefore representative not of the entire popuation of banks in transition economies, but rather of the reativey successfu top tier of banks in the region. The data on tota revenues and operating costs of banks come from the income statement and baance sheets of the sampe banks, as reported in the BankScope database. Tota bank revenues incude net interest income pus non interest income

22 Costs incude genera operating expenses, but not interest expenses. Bank dividend payments are aso excuded from the measure of tota cost. We use four items from the baance sheets of banks incuded in the BankScope database. Customer oans and customer deposits incude a oans made to and deposits received from non-bank entities. Non-oan financia assets are the other earning assets of a bank ess inter-bank deposits paced with other banks. This amount incudes the securities hed by a bank. Bank equity incudes tota paid-in capita pus retained earnings. Bank origin and ownership are divided into five separate types. Private banks with no state-owned antecedents are referred to as newy estabished banks and they are distinguished by whether their majority owners are domestic or foreign entities. Private banks that were formery state-owned or part of a state-owned bank are referred to as privatised banks. They too are distinguished by whether their majority owners are domestic or foreign entities. The fifth bank ownership type is state owned. Data on the origin and ownership is from EBRD staff research and varies over time for each bank. Regarding measures of competition and market structure, the centra banks of the countries covered by the study provided data on the number of banks and the tota amounts of oans and deposits in the banking systems. These data on tota amounts of oans and deposits, together with the bank-eve data, were used in cacuating the oan and deposit market shares of individua banks. For input prices, we use the oca currency wages in the financia sectors as reported by the nationa statistica agencies of the countries incuded in the sampe and convert these amounts into US doars using period average exchange rates. We aso use the rea interest rate as measure of the opportunity cost of using physica

23 capita in the production of banking services. The rea interest rate is measured ex post as the difference between the nomina interest in the money market at the beginning of the year and the consumer price infation rate in that year. In the cost equation, we aso incude the equity to asset ratio as proxy measure for other unobservabe characteristics of banks that reate to their abiity to contro costs. A higher equity ratio, for exampe, may be positivey correated with the capabiities of bank managers. Tabe 2 summarises the dataset that we use in the anaysis. It reports sampe means for the dependent and expanatory variabes for each of the five bank origin and ownership categories used in the estimations. The tabe aso provides average ratios to tota assets for revenues, operating costs and profits before taxes. These data indicate that privatised banks and state banks tend to be arger than newy estabished banks with greater market shares. They aso show that foreign banks tend to have ower revenues and operating costs reative to tota assets than do domestic banks and that state banks are on average the east profitabe banks. 6. Resuts Revenue equation Tabe 3 reports the resuts of the estimations of the revenue equation for the two sub-periods, 1995 to 1998 and 1999 to Our preiminary investigations of bank margins indicated that they vary significanty over time. Partitioning the sampe in this way divides it roughy in haf in terms of numbers of observations and this aow us to see how any effects of competition and bank origin and ownership change over time. We in addition report two versions of the revenue equation. In one 4 Whie the data set incudes observations from 1994, this year is dropped from the sampe period for

24 specification the dependent variabe is tota revenue and in the other it is tota revenue ess an adjustment for the effect of infation on bank capita. This adjustment subtracts from bank revenue the extent to which the rea vaue of bank capita at the mid-point of each year has been eroded by infation over that year. The reason for making this adjustment is that in infationary environments banks tend to increase their margins in order to maintain the rea vaue of bank capita. Therefore, the estimated coefficient on bank capita may refect both the inter-bank interest rate and the effect of infation on the rea vaue of bank capita. In the estimations without this adjustment to revenues, the estimated coefficient on bank capita is significanty above its theoreticay predicted vaue. The estimations yied a number of interesting resuts regarding the effects of bank origin and ownership. The estimated coefficients on the vaue of oans and deposits are the average margins earned by state-owned banks above a set of constants that contro for country and time fixed effects. The estimated coefficients on the other expanatory variabes indicate how their margins change from this base vaue. The comparative static properties of the mode are investigated using the combined vaue of oans and deposits rather than these variabes separatey because they are highy coinear. In the earier sub-period and with unadjusted revenue as the dependent variabe, the average margin earned on oans is 3.6 per cent, whie that on deposits is not significanty different from zero. Other factors being equa, the average margins on the combined vaue of oans and deposits of newy estabished domestic and foreign banks are not significanty different from those of state banks. However, the average margins of privatised banks with majority domestic and foreign ownership are about one to 1.5 percentage points above those of state-owned banks the estimations because agged expanatory variabe vaues are incuded in the regressions as instrumenta variabes

25 and newy estabished banks. In the estimations with revenues adjusted for the erosion of bank capita by infation as the dependent variabe, we obtain simiar parameter estimates. If bank origin and ownership are associated with the incentive and capabiity of a bank to increase the demand for its oans and deposits and to contro its costs, this pattern of margins in the earier sub-period suggests that privatised banks increased their margins reative to those of state-owned banks either because they were abe to increase the demand for their oans and deposits or because their costs rose. Simiary, newy estabished banks may have been abe to reduce their margins beow those of state-owned banks because they were either abe to contro their costs or unabe to increase demand for their oans and deposits. Whie evidence on costs reported beow show that newy estabished foreign banks have margina costs that were significanty ower those of other types of banks in the earier sub-period, privatised bank may have had a greater incentive and capacity to attract demand for their oans and deposits because of their more estabished reputations in the market and their private ownership reative to those of newy estabished banks and state-owned banks. In the ater sub-period and the estimation that does not adjust revenues for infation, the average margin earned by state-owned banks on oans is -2.7 per cent, whie that on deposits is not significanty different from zero. The margins earned by a private banks are significanty above those of state-owned banks. Other factors being equa, the margins earned by newy estabished domestic and foreign banks on their oans pus deposits are 3.2 percentage points and 2.3 percentage points higher, respectivey, than those of state-owned banks. At the same time, the margins of privatised banks, both domestic and foreign, are about 2 percentage points higher. Again, in the estimations that use infation-adjusted revenues as the dependent

26 variabe, simiar variation in average margins by bank ownership is observed. There is therefore significant convergence in the ater sub-period among the average margins earned by private banks above a set of constants that contro for country and time effects. The convergence in margins among private banks may refect either a convergence in margina costs among banks (considered beow) or in the abiity of newy estabished banks to attract greater demand for their oans and deposits over time. For exampe, newy estabished banks that remained in the market may have deveoped reputations that enabed them to compete more effectivey for customers with the privatised banks. In contrast, state-owned banks may have had neither the incentive nor capacity to increase the demand for their ending and deposit taking services, whie the absence of a profitabiity constraint may have aowed these banks to remain in the market despite depressed oan margins. Regarding the effects of competitive pressure as measured by the number of banks per popuation in a country, there is evidence of competitive pressures associated with the number of banks per miion of popuation. Whie in a regression specifications the estimated coefficient is negativey signed, it is statisticay significant ony in the specifications that use infation-adjusted revenues. In earier sub-period, as the number of banks per miion of popuation increased by one the average margin on oans pus deposits decined by about 1.4 basis points. In the ater sub-period the magnitude of this effect is somewhat smaer, at about 0.9 basis points. This finding is consistent with out mode of monopoistic competition in which competitive pressures increase with the number of banks in the market, but it inconsistent with the empirica findings of Yidirium and Phiippatos (2002b), which finds that competitive pressures increased over time in transition banking. The correation between the weighted average market share of oans and

27 deposits and the average margin earned on them is positive and significant in a the estimations. In each, an increase in market share of one percentage point is associated with a one to 1.5 basis point increase in the margin earned on oans and deposits. This is consistent with the oans and deposits of banks being imperfect substitutes, a basic assumption of our mode of monopoistic competition in banking. This finding is aso consistent with the previous empirica resuts of Geos and Rodós (2002), Yidirim and Phiippatos (2002b) and Drakos and Konstantinou (2003) The average margin on non-oan financia assets in the earier sub-period is not significanty different from zero, whie that in the ater sub-period is in the range 5.6 per cent to 8.0 per cent. With the possibe exception of the earier sub-sampe, which incudes periods of macroeconomic instabiity in most of the countries incuded in the sampe, these are pausibe estimate vaues. In the estimation with use unadjusted revenues, coefficient on bank equity for the earier sub-period is 32.7 per cent, whie that for the ater sub-period is 29.8 per cent. These coefficients are estimates of the inter-bank rate, but are somewhat high compared to the actua rates. In the estimations that adjust revenues for infation, the coefficient on bank equity in the earier sub-period is 25.5 per cent, whie that for the ater sub-period is 18.3 per cent. The estimated revenue equations aso incude a dummy variabe that indicates whether a bank reported according to internationa accounting standards. In the three estimations in which this variabe is statisticay significant, the average margin on oans pus deposits earned by banks that report according to internationa standards is about one percentage point ower, other factors being equa. Cost equation

28 Tabe 4 reports the estimation resuts for the trans-og cost equation for the two sub-periods, 1995 to 1998 and 1999 to As with the revenue equation, this partitioning of the dataset aows us to see how the costs of providing banking services changes over time. The reported form of the estimated trans-og cost function incudes the firstand second-order terms of the vaue of oans and deposits. The expanatory variabes aso incude the vaue non-oan financia assets, the two input prices (US doar wages and the rea ex post interest rate at the country eve), the ratio of bank equity to tota assets and dummy variabes for bank origin and ownership. An initia specification of the trans-og cost function incuded a of the higher order terms and those that aowed for interactions with bank origin and ownership and with the two sub-periods, but most were eiminated because they were statisticay insignificant. Because the vaue of oans and deposits are highy coinear, we aso estimate a cost function in which their vaues are combined into a singe scae variabe as a consistency check. The estimation provides a number of interesting resuts regarding the association between bank origin and ownership and cost efficiency. Compared with state-owned banks, most types of private banks are more cost efficient. This effect can be seen from the fact that the dummy variabes for bank origin and ownership are significanty negative for the three of the four types of private banks in the earier subperiod, newy estabished banks and privatised banks with majority domestic ownership. The effect is argest for newy estabished foreign banks. Perhaps surprisingy, privatised banks with majority foreign ownership do not appear to expoit potentia cost savings reative to state-owned banks. In the ater sub-period, newy estabished banks (particuary those with majority foreign ownership) continue to be more cost efficient than other banks, athough this competitive advantage is

29 smaer in size compared with that in the earier period. At the same time, there are no differences in the cost of efficiency of privatised and state-owned banks. For the purpose of comparison with the variation in average margins on oans pus deposits estimated from the bank revenue equation, the margina costs can be cacuated from the estimated coefficients of the cost equation (that is, the estimated cost easticities) and from the average costs and the average vaues of oans and deposits for the different types of banks. In the earier sub-period and the specification of costs that in which combines vaue of oans and deposits, 5 the margina cost evauated at the sampe mean of a newy estabished foreign bank in providing a unit of oans pus deposits is 2.6 per cent and that of a privatised bank with majority foreign ownership was 3.9 per cent. The margina costs evauated at the sampe means for domestic banks are somewhat higher, 4.4 per cent for newy estabished banks and 5.1 per cent for privatised banks. The margina cost evauated at the sampe means of state-owned banks is 5.4 per cent. The margina costs of newy estabished foreign banks are significanty ower than those of state-owned banks. The differences in margina costs among other banks are not statisticay significant. This finding is consistent with the entry of new foreign banks introducing ower margina costs in the provision of banking services and increasing competitive pressure on other banks, at east in the short-run. In the ater sub-period, the differentiation among banks in terms of their margina costs evauated at the sampe means diminishes. The margina cost of newy estabished foreign banks remains broady unchanged a 2.3 per cent and somewhat beow that of other banks. The margina costs of other types of banks were 3.1 per 5 We cacuate the margina costs by bank origin and ownership based on the cost function using the combined vaue of oans and deposits because muticoinearity eads to high standard errors of the estimated parameters of the cost function when their vaues are entered separatey. The estimated margina costs by bank origin and ownership are approximatey the same in these two specifications,