Bank Competition and the Lending Channel in Transition Countries Fariz Huseynov 1 Rustam Jamilov 2 Wei Zhang 1 First draft: October 2013 Abstract: We investigate the impact of bank competition on the bank lending channel of monetary policy transmission in 29 transition economies over the period of 1996 to 2011. Our measures of bank competition are the dynamic Panzar-Rosse (1987) statistic and the EBRD structural transition indicator. We find that increased bank competition strengthens the effectiveness of the bank lending channel suggesting that high bank competition is favorable for the conduct of monetary policy. This effect is evident both in expansionary and contractionary monetary policies. Further analysis indicates that the association between bank competition and the bank lending channel is more related to increased competition among small banks. We also find that high bank competition is likely to increase the impacts of the monetary policies in countries with lessdeveloped financial markets. We discuss the policy implications of our findings. Keywords: bank competition, lending channel, transition, monetary policy. 1 College of Business, North Dakota State University, Dept. 2410, P.O. Box 6050, Fargo, ND 58108. Email: fariz.huseynov@ndsu.edu (corresponding author); wei.zhang@ndsu.edu. 2 London School of Economics. Email: R.Jamilov@lse.ac.uk 1
1. Introduction Prior literature on the mechanisms of monetary policy transmission suggests that monetary policy can affect the real economy both through interest rates on credit markets and through the supply of bank loans, i.e. the bank lending channel. Changes in monetary policy may alter the deposit and loan supply schedules of banks. When banks cannot offset the negative effects of monetary tightening by accessing additional funding sources, they tend to reduce the size of their loan portfolios and curtail the real economy. The effectiveness of monetary policy through the bank lending channel is essential in countries with less-developed financial markets where borrowers mostly rely on banks for funding opportunities (Adams and Amel, 2005). Several studies (Kashyap and Stein, 1995, 2000; Kishan and Opieal, 2000; Matousek and Sarantis, 2009) emphasize that various measures of the strengths of banks balance sheets, such as asset-size, liquidity, and bank capitalization may determine how sensitive a bank is to monetary shocks. Some others (Aftalion and White, 1978; VanHoose, 1983, 1985; Adams and Amel, 2005; Cetorelli and Goldberg, 2009; Olivero, Li, and Jeon, 2011) suggest that the structure of banking sector and bank competition can determine the transfer of capital shocks to bank lending and therefore play a significant role for the effectiveness of monetary policy. Bank competition may affect the efficiency of monetary policy transmission through the bank lending channel in several ways (Olivero et al. 2011). If competition rises due to the increased market share of large banks, the effectiveness of the bank lending channel will diminish because the monetary policy shocks have a lesser impact on the availability of the funds to larger banks. However, if competition for funding sources makes banks more sensitive to changes in the cost of capital, monetary policy shocks will be transmitted to lending markets, hence strengthening the effectiveness of the monetary policy. The empirical evidence is mixed 2
depending on the nature or the measure of competition. Adams and Amel (2011) find that the effectiveness of monetary policy is stronger if transmitted through less concentrated banking markets. Specifically, more concentrated markets have lower business loan originations and experience smaller changes in business loan originations in response to changes in the federal funds rate. Cetorelli and Goldberg (2012) analyze the liquidity management in global banks and find that global banks are more able to insulate the effects of domestic monetary shocks, while banks without global operations are more affected by domestic monetary policy. Olivero, Li, and Jeon (2011) use a Panzar and Rosse (1987) measure of bank competition and find that high competition in the banking sector weakens the transmission of monetary policy through the bank lending channel in selected Latin American and Asian countries. Although Matousek and Sarantis (2009) document the existence of the bank lending channel in transition economies, the impact of bank competition is yet to be investigated for these economies. Since mid-90s, transition economies have passed through frequent structural changes, such as financial sector reforms, privatization of state-owned banks, consolidation, improved lending conditions, and strengthened governance mechanisms. These regulatory and institutional reforms have had a significant impact on bank competition that is an important determinant of banks operational efficiency and profitability (Fang, Hasan, and Marton, 2011). Brissimis, Delis, and Papanikolaou (2008) analyze 10 newly acceded EU countries and find that both banking sector reform and competition increase bank efficiency. Cojocaru, Hoffman, and Miller (2013) conclude that reduced bank competition hampered economic growth in the former Communist countries. The lack of bank competition also limits access to financing in countries with low levels of economic and institutional development, including transition economies (Beck, Demirguc-Kunt, Maksimovic, 2004). Under certain circumstances, bank competition may 3
increase risk-taking behavior in these countries (Agoraki, Delis, Pasiouras, 2011) and, in turn, increase financial instability through lowering institutional quality of the overall financial sector. Schaeck, Cihak, and Wolfe (2009) find that more competitive banking systems are less prone to experience a systemic crisis. Overall, prior literature suggests that bank competition has important implications for the economic and financial development of transition economies. During the last two decades the central banks in transition countries have improved the effectiveness of their monetary policies through various inflation and exchange rate targeting policies, however, due to the inefficient legal systems and the lack of well-functioning capital markets, the banking sector is still the dominant financing channel in transition countries. Matousek and Sarantis (2009) document the existence of the bank lending channel in selected Central and Eastern European countries, although the strength varies depending on the bank size and liquidity. In most transition countries with the exception of few, banking market operates in three-tiered system, where few state-owned banks dominate the market by their asset size, and large and small private banks compete within their categories. While large private banks are generally able to secure loans from international financial institutions and insulate themselves from domestic monetary shocks, the integration to Western financial world exposes large banks to global monetary shocks. Small and medium banks are more vulnerable to changes in domestic monetary policies and affect the economic well-being of their dependent clients. While previous studies have examined the interplay between bank competition and the bank lending channel in developed and selected developing countries, that relationship in transition economies still needs to be investigated. Our study aims to fill this gap. In this paper we examine the impact of bank competition on the transmission of monetary policy through the bank lending channel in transition economies using a large panel of bank- 4
level balance sheet and financial statement data from 29 countries of Central and Eastern Europe, and the Commonwealth of Independent States (CIS) over the period from 1996 to 2011. As a first step of our estimation procedure, we apply the Panzar and Rosse (1987) methodology to compute both the static and dynamic measure of the level of bank competition in each of the transition countries. We find that the banking industry in transition countries is moderately highly competitive, possibly under monopolistic competition. This confirms the literature consensus (Bikker and Spierdijk, 2008; Bikker et al., 2009, Olivero et al., 2011) that bank competition in developing economies tends to be higher than in the developed world. Both static and dynamic Panzar and Rosse (PRH) estimates of competition are similar across countries suggesting that bank sectors in transition economies share a common transition factor when it comes to market competition. In addition to using the PRH statistic as a proxy for bank competition, we also use Transition index that ranges from 1 to 4 according to the competition policy score assigned to each transition country by the European Bank of Reconstruction and Development (EBRD). This index ranks transition countries by the overall degree of their financial sector development based on monetary freedom, financial sophistication, competition in financial markets etc. The use of the Transition index along with the PRH statistics allows us to measure the impact of not only the competition estimated from bank related variables, but also that of the overall competitiveness of the financial sector.. In the context of our research, the Transition index also enables us to measure the institutional qualities that contribute to bank competition but are not captured by the PRH statistics. In the second step, we analyze the impact of bank competition on the bank lending channel in transition countries by employing the Kashyap and Stein (1995, 2000) model that estimates 5
lending behavior at the individual bank level. In this model, we introduce our bank competition proxies, the PRH statistic and Transition index, and their interaction with the monetary policy rate as the key explanatory variables. We find that the loan growth is negatively related to bank competition, especially among small banks. Thus, high bank competition reduces the growth rate of bank loans in transition countries. The most important finding of our paper is that bank competition strengthens the transmission of monetary policy through the bank lending channel in transition economies suggesting that when bank competition rises, the effectiveness of monetary policy increases in these economies. Our findings are broadly consistent with the results of Adams and Amel (2011) who conclude that the impact of federal funds rate is stronger if transmitted through less concentrated banking markets. However, our findings differ from the results of Olivero et al. (2011) who find that high bank competition weakens the bank lending channel related in selected Latin American and Asian countries. This suggests that the nature of the bank lending channel in transition countries differs from that in other developing nations. High bank competition in transition countries may be caused by an increased market share of small banks that are more sensitive to monetary policy shocks. When we use two PRH statistics measuring bank competition among small and large banks separately, we find that only an increase in bank competition among small banks strengthens the bank lending channel of monetary policy transmission and the competition among large banks does not have a significant impact. It is possible that large banks are able to retain their customers during adverse monetary policy shocks, possibly due to high switching costs of depositors hence being able to withstand the negative consequences of a tightening money supply. Alternatively, increased competition among large banks is likely to force them to seek for additional sources of capital, hence to insulate them from domestic monetary policy 6
shocks. When we examine the impact of bank characteristics, our results suggest that an increase in bank competition strengthens the effectiveness of monetary policy transmission in banks with high levels of liquidity, capitalization, and profitability. Several studies (for example, Kishan and Opiela, 2006 and Jamilov, 2012) argue that the bank lending channel performs differently under asymmetric monetary shocks. Therefore, we investigate whether the impact of bank competition on the transmission of monetary policy shocks is different for contractionary and expansionary monetary policies in transition countries. The results show that loan growth is negatively related to bank competition regardless of the direction of monetary policy. However, higher bank competition decreases (increases) the growth rate of bank loans when monetary policy is tightening (expanding). Thus, bank competition strengthens the effectiveness of both contractionary and expansionary monetary policy shocks. We also conduct a separate regional analysis of four regions, namely the Caucasus, Central Asia, Central and Eastern Europe, and Southeastern Europe. At least one of our bank competition variables indicates that loan growth is positively (negatively) related to bank competition in Caucasus (Central-Eastern Europe). The impact of bank competition on loan growth is mixed for Central Asia. Consistent with our previous findings, we find evidence that high bank competition in all regions strengthens the bank lending channel and the effectiveness of monetary policy. Adams and Amel (2005) argue that the bank lending channel is most important in countries with limited borrowing alternatives to bank loans. The development of capital markets, especially equity and bond markets, enables borrowers to switch to these venues when the bank lending markets are adversely affected by monetary policy shocks. We use the MSCI market 7
classification as a proxy for financial market development and group our countries into three groups - Emerging, Frontier, and Other. The last group consists of countries that are not included in any of the first two market groups. We find that high bank competition is associated with a faster (slower) lending growth in transition economies with less (more) developed financial markets. We also find that an increase in bank competition is likely to strengthen the effectiveness of the monetary policy transmission mechanism in countries with less developed financial markets. The contributions of our paper are threefold. First, we extend the rather limited literature on the impacts of bank competition on monetary policy transmission to the context of transition economies. The nature of institutional reforms and banking sector development during the transition from central planning to a market economy sets transition economies apart from their counterparts where most prior studies have focused. Second, we extend the bank competition literature by examining market competition among small and large banks separately. We identify the underlying sources of the positive impact of bank competition on the monetary transmission mechanism. Our results show that increased competition among small banks strengthens the effectiveness of the bank lending channel. Finally, we expand the literature on the bank lending channel by examining the impact of bank competition on the transmission of contractionary and expansionary monetary policies separately. Our study also investigates how financial market development affects the effectiveness of the bank lending channel in transition economies. The remainder of the paper is structured as follows. In Section 2, we present the data and research design. In Section 3, we report our test results and discuss their implications. Finally, Section 4 concludes. 8
2. Data and Methodology We obtain annual bank-level balance sheet and income statement data for the 1996-2011 period from the BankScope database. Our dataset includes an unbalanced panel of 9548 bankyear observations from 29 transition countries. 2 We also collect short-term interest rates and macroeconomic variables (GDP and CPI) for each country from the International Financial Statistics and World Bank s Development Indicators. We conduct our empirical tests in two steps. First, we obtain our bank competition measures. Our first measure is the H statistics (PRH) estimated based on the Panzar and Rosse (1987) model. PRH statistic measures the relation between bank revenues and the marginal cost of the inputs for providing banking services. We follow the methodology of Goddard and Wilson (2009) and construct a dynamic panel model of the revenue equation to estimate the level of competition in the banking market for each country. We prefer the dynamic PRH statistic to the static PRH statistic because it includes a lagged dependent variable to allow for a partial adjustment towards the long-run equilibrium. Following Goddard and Wilson (2009) we apply Arellano and Bond s (1991) generalized method of moments estimator (GMM) to conduct the first-difference estimation of the revenue function as in Equation (1): ln(ir i,t ) = β 0 ln(ir i,t 1 ) + β 1 ln(f 1,i,t ) + β 2 ln(f 2,i,t ) + β 3 ln(f 3,i,t ) + Z i,t + ε i,t (1) where the IR is interest income to the total assets ratio, Fj,i,t (j=1,2,3) are the cost factors that include interest expenses, personnel expenses, and other operating expenses, all scaled by total assets. Zi,t is the vector of bank-specific control variables that include the ratio of equity to total assets, the ratio of net loans to total assets, and the ratio of other income to total assets. The choice of variables is consistent with Bikker et al. (2009), Panzar and Rosse (1987), and Olivero 2 These countries include Albania, Armenia, Azerbaijan, Belarus, Bosnia, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Hungary, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Macedonia, Moldova, Montenegro, Poland, Romania, Russia, Serbia, Slovakia, Slovenia, Tajikistan, Turkey, Turkmenistan, Ukraine, and Uzbekistan. 9
et al. (2011). The PRH statistic is calculated by(β 1 + β 2 + β 3 )/(1 β 0 ). A PRH value smaller than zero indicates monopoly; under perfect competition it is equal to one. When the PRH statistic is in the range between zero and one, the banking industry is considered to be under monopolistic competition. Following Bikker and Haaf (2002) and Olivero et al. (2011), we assume the PRH statistic is a continuous measure of the degree of competition, where larger values indicate stronger competition. As our second measure of bank competition we use Transition index that ranges from 1 to 4 according to the competition policy index assigned to each transition country by the European Bank of Reconstruction and Development (EBRD). This variable measures the overall financial sector development in transition countries by ranking these countries based on the monetary freedom, financial sophistication, competition in financial markets etc. We obtain the annual series of this variable from EBRD. Similar to the PRH statistic, the larger values of Transition index signal the higher levels of overall competitiveness in the financial sector. In the second step of our estimation, we use the PRH statistic and Transition index as proxies for bank competition in each country and examine the impact of bank competition on the transmission of monetary policy through the bank lending channel. Following Kashyap and Stein (1995), we build a loan growth model that regresses the growth rate of annual loans by each bank in each country on the monetary policy rate, a measure of bank competition, and an interaction term between these two. The model also includes the bank-specific control variables. Thus, the coefficient of the PRH or the Transition variables indicates the impact of bank competition on the growth rate of bank loans; the coefficient of the interaction term captures the impact of bank competition on the effectiveness of the bank lending channel. Our model is defined by Equation (2): 10
ln(l) i,t = t i α j t i µ j (2) ln(l) i,t j + t i β j (PRH i,t or Transition i,t ) (MP) i,t + t i θ j (MP) i,t j + t i p j (PRH i,t or Transition i,t ) + 11 W i,t j + t i δ j Z i,t 1 + φ i + ε i,t where L i,t are real loans, MP i,t is the monetary policy rate, W i is a vector of macroeconomic control variables such as real GDP growth and CPI, Z i is a vector of measurable bank-specific characteristics, φ i represents the idiosyncratic bank effects, and ε i,t is the error term. For the monetary policy rate we use the market real interest rate assuming that this rate closely follows the main policy rate of monetary regulator in each country. We expect a negative association between the monetary policy rate (MP) and the growth rate of loans indicating that an increase in interest rates reduces bank lending. This would also signal whether the interest rate channel of monetary policy transmission exists in transition countries. The expected signs of bank competition variables (PRH and Transition) and their interaction with the monetary policy rate on the lending growth are ambiguous depending on the nature of changes to bank competition discussed in Section 1. A positive (negative) sign for a bank competition variable indicates that an increase in bank competition is associated with an increase (decrease) in the growth of bank loans. A positive (negative) sign for the interaction between a bank competition variable and the monetary policy rate suggests that an increase in bank competition weakens (strengthens) monetary policy transmission through the bank lending channel. We control for several bank characteristics including size, liquidity, capitalization, and profitability that are expected to affect the lending behavior of a bank. We assume that banks of larger size, higher liquidity, greater capitalization, and higher profitability are more likely to have access to alternative sources of internal and external funding and hence more likely to mitigate the negative impact of decreasing deposits as a result of unexpected monetary policy shocks. We use a relative measure of size by calculating the difference between the natural log of banks
total assets and the average of the log of assets for all banks in that country for the given year as follows: Size i,t = ln TA i,t i ln TA i,t N t (3) We measure liquidity as the ratio of the sum of cash and reserves to total assets. Our measure of capitalization is calculated as the ratio of equity capital to total assets, and profitability is computed as the ratio of net income to total assets. All control variables are calculated at the bank level. One concern with including bank-specific control variables into the equation (2) is that the coefficient estimates of these variables might be biased due to endogeneity issues. For example, if a smaller bank may also have higher capital and liquidity because it may face higher costs associated with financing constraints. Therefore, to minimize the endogeneity of our control variables, we estimate equation (2) by applying two-stage least squares (2SLS) randomeffects panel IV regression method where we use the lag of our bank-specific factors as instruments. 3. Empirical Results 3.1. Summary statistics Table 1 presents the number of banks included from each of 29 transition countries covered in our dataset over the period of 1996 to 2011. Total number of banks in transition countries has steadily increased from 1996 until 2008 since when the number of banks has declined almost in each country. One possible explanation is that as a response to negative effects of the 2008 financial crisis many struggling banks in transition countries have been consolidated or acquired by other banks. Alternatively, the transparency of the banking sector may have declined in certain countries and the coverage of bank-level financial data was reduced after 2008. This is 12
more evident in countries such as Russia, Ukraine, Turkey, and Czech Republic. The region with the largest number of bank-year observations included in our dataset is Central and Eastern Europe (CEE) followed by Central Asia. Turkey and Poland are the countries with the largest and Turkmenistan and Tajikistan are the countries with the smallest number of bank-year observations in our dataset. 3.2. Bank Competition In the first step of our estimation procedure, we estimate the level of bank competition measured as the dynamic PRH statistics for each country using equation (1). Panel A in Table 2 reports the estimated dynamic PRH statistics. In all countries in our sample, except Turkey, the dynamic PRH statistics are less than one suggesting that banking sectors of these countries are suffering from monopolistic competition. Bank competition is highest in Turkey, Romania, and Hungary, while lowest in Macedonia, Serbia, Russia, and Bulgaria. Our average PRH statistics for CEE and Caucasus are 0.809 and 0.763, respectively, and are higher than those for Southeast Europe (0.553) and Central Asia (0.561). This suggests that bank competition is higher in CEE and the Caucasus. The average PRH statistic for transition countries is 0.672. The PRH values do not exhibit large variations across the individual countries suggesting that the banking sectors in transition economies carry a common transition factor that contributes similarly to the bank competition. Overall, our findings on the degree of bank competition in transition countries are consistent with prior studies that have found higher degree of bank competition in developing countries than in some developed countries (e.g. Bikker, et al., 2009; Olivero et al., 2011). 13
Table 2 also reports the average, minimum, and maximum scores of the Transition index for each country during the sample period. 3 While Central and Eastern European countries have the highest average Transition scores, Central Asian countries have the lowest average Transition scores. The average Transition scores of Hungary, Slovakia, and Poland are the highest among countries in our sample and those of Uzbekistan, Moldova, and Tajikistan are the lowest. 3.3. Bank Competition and Bank Lending Channel In the second stage of our estimation procedure, we use the dynamic PRH statistics and Transition scores and their interaction with monetary policy rate in Equation (2) to measure the impact of bank competition on the bank lending channel of monetary policy transmission. We also control for bank characteristics, such as size, liquidity, capitalization, and profitability that are found in prior studies to affect loan growth. We report the estimation results in Table 3. In the baseline model (Column 1), we find that loan growth is negatively associated with monetary policy rate which is consistent with the interest rate channel that the growth rate of loans increases when the monetary policy rate decreases. The coefficients of GDP growth and CPI have expected signs on loan growth, such that the growth rate of bank loans is positively related to economic growth that stimulates the demand for loans, and negatively related to the inflation rate. In Column 2, we find that the growth rate of bank loans is negatively associated with bank competition (PRH) suggesting that bank loans grow slowly in transition countries with high bank competition. One plausible explanation is that the existence of information asymmetry in transition countries impedes the increase in lending. Consistent with information-based hypothesis under the information asymmetries between lenders and borrowers, the large banks in 3 EBRD does not assign a Transition score for Turkey and Czech Republic. 14
competitive markets are less likely to increase loans. It is also possible that when small banks enter the market, large banks reduce the amount of loans loaned to the certain segments of lending markets. We also find that while the monetary policy rate is insignificant, the interaction between bank competition and the monetary policy rate has a negative (weakly significant) impact on the growth rate of bank loans. Bank competition in transition countries is likely to strengthen the transmission of monetary policy through the bank lending channel. In other words, high bank competition strengthens the impact of monetary policy shocks on the lending market and possibly on the real economy. One interpretation is that increased bank competition stems from increased market share of smaller banks that are more likely to be affected from domestic monetary policy shocks. The borrowers costs of switching to another lender may remain high even when the competition among banks rises and monetary policy shocks are transferred to these clients, especially through smaller banks. The coefficient of monetary policy rate becomes insignificant when we include bank competition suggesting that interest rate channel may not work properly when bank competition is controlled. Our findings on bank characteristics suggest that banks with smaller size, lower liquidity, lower capitalization and greater profits in transition countries have faster growth rate of loans. Our results on bank competition are similar to Adams and Amel (2011) who find a positive association between bank competition and the bank lending channel in the U.S. banking markets, but differ from Olivero et al. (2011) who find evidence of negative impact of bank competition on the bank lending channel in selected developing countries. The dynamics of bank competition and monetary policies in transition countries seem to differ from other developing countries. 15
Bank competition may increase or decrease due to changing competition forces among large and small banks. The impact of increased competition among large banks on the transmission of monetary policy shocks usually differs from that of increased competition among small banks. When competition among large banks increases, they may attempt to obtain more external funding opportunities to be insulated from domestic monetary shocks. However when competition among small banks increase, these banks are more likely to build strong relationship with their borrowers hence increase their switching costs. Therefore, we calculate dynamic PRH statistics for small and large banks separately for each country and examine the impact of bank competition among small (large) banks on the small (large) bank lending channel of monetary policy transmission. Our design on small and large banks differs from Olivero et al. (2011) who use the PRH statistics that measures the competition among all banks in each country. Columns 3 through 5 in Table 3 report our results. Our findings indicate that while bank competition among small bank has a negative impact on loan growth in small banks, bank competition among large banks has no significant impact on loan growth in large banks. Increased competition among small banks may hurt their ability to attract new clients and expand their customer base. The coefficients of interaction terms indicate that small and large bank competition has s positive impact on the growth rate of loans issued by small and large banks, respectively. High bank competition strengthens the monetary policy transmission separately through small and large banks, respectively. In Column 5, we include the PRH statistics for small and large banks and their interaction with the monetary policy rate into our regression for the entire dataset. This way we are able to separate the impacts of the competition among small and large banks and their interaction with the monetary policy rate on the growth rate of loans held by the entire set of banks. We find that when competition among small banks increases, loan 16
growth rate decreases and the effectiveness of the monetary policy transmission mechanism through small bank lending channel strengthens. We find no evidence for a significant impact of the competition among large banks on loan growth of entire banking system and on monetary policy transmission. Overall, our findings on small and large bank competition suggest that monetary policy transmission through the bank lending channel strengthens especially when competition among small banks rises. This is consistent with the view that high competition among large banks forces them to insulate themselves from domestic monetary shocks, while increasing competition is likely to make small banks more vulnerable to domestic monetary policy shocks (Olivero et al. 2011; Cetorelli and Goldberg, 2012). In Column 5 of Table 3 we present our results for the impact of Transition level, our second proxy for bank competition, on the transmission of monetary policy shocks. Similar to our results for the PRH statistics in Column 2, the coefficients of both Transition index and its interaction with the monetary policy rate are negative for loan growth. The higher level of competition in financial sector causes a decrease in the growth rate of loans, but a stronger transmission of monetary policy. The significance of the interaction between Transition and the monetary policy rate is stronger suggesting that the institutional improvements towards increasing competition in the financial sector increases the effectiveness of the transmission of monetary policy shocks. Table 4 presents our results on the effects of bank characteristics such as asset size, liquidity, capitalization, and profitability on the association between bank competition and the bank lending channel. Our findings in Panel A 4 indicate that the coefficient of the PRH statistics is negative in all groups of bank characteristics suggesting that bank competition is negatively associated with loan growth regardless of the bank characteristics. However, the interaction 4 We do not separate banks into size groups when we use PRH statistics in Table 4, because we conduct a more rigorous analysis of the impact of bank size in Table 3 above. 17
between bank competition and the monetary policy rate is insignificant for all groups. In Panel B, we find that similar to the PRH statistic, Transition index has a negative coefficient for loan growth regardless of bank characteristics. However, different from the PRH statistic, Transition index shows variation between different bank characteristics for the impact of competition in the financial sector on the transmission of monetary policy shocks. Higher levels of transition index strengthens the transmission of monetary policy through both small and large banks, and high liquidity, high capitalization, and high profitability banks. 3.4. Bank Competition and Asymmetry in Monetary Policy In the previous section we examined the impact of bank competition on the monetary policy transmission without separating contractionary monetary policies from expansionary monetary policies. Kishan and Opiela (2006) and Jamilov (2012) argue that the bank lending channel and regulatory policies are differently affected from asymmetric monetary policies. While contractionary policies can negatively affect the bank lending by low-capital banks, expansionary policies do not always stimulate lending growth. Following the prior literature, we separate our sample into two groups - monetary contraction phase that includes only negative shocks to the policy rate and monetary expansion phase that includes only positive shocks to the policy rate. Our goal is to examine the impacts of bank competition on the bank lending channel of the transmission of contractionary and expansionary monetary policies separately. Table 5 reports our results for both the PRH statistic and Transition index used as proxies for bank competition. We find that regardless of the direction of monetary policy changes, both proxies of bank competition have negative impact on loan growth in transition countries. Thus, whether the regulator implements a monetary policy tightening or a monetary policy expansion, 18
high bank competition decreases the growth rate of bank loans. However, our findings also indicate that the coefficient of the interaction between the PRH statistic and the monetary policy rate is negative for loan growth during contractionary monetary phases, while that is positive during expansionary monetary phases. Thus we find evidence that high bank competition strengthens the effectiveness of monetary policy shocks during the periods of both monetary tightening and monetary expansion policies. In a monetary policy tightening (expansion) high bank competition strengthens the effects of monetary policy shocks and is associated with a decrease (an increase) in the growth rate of bank loans. The interaction between Transition index and the monetary policy rate is insignificant in both monetary phases. 3.5. Bank Competition and the Bank Lending Channel across the Regions In the previous sections we use the entire dataset over all transition countries to examine the impact of bank competition on the bank lending channel of the monetary policy transmission. Although, all these countries share a common transition factor, their geographical location, relations with the European Union and the different levels of integration to international financial markets can have differing impacts on their overall economy and the development of financial sector. We separate the countries in our sample into four regions, namely Caucasus, Central Asia, Central-Eastern Europe, South-Eastern Europe, and examine the relationship between bank competition and monetary policy transmission separately for each region. Table 6 reports our results. We find that the PRH statistic is significant and positive for loan growth only in Central Asia and Transition index is positive for loan growth in Caucasus, and negative in Central Asia and Central-Eastern Europe. Thus we have mixed results for the impact of bank competition on the growth rate of bank loan across the regions. However, the interaction 19
between at least one of the bank competition measures and the monetary policy rate is negative for the loan growth in all regions. These results suggest that high bank competition in all regions strengthens the bank lending channel and the impacts of monetary policy shocks on bank lending growth. 3.6. Impact of Financial Market Development and Transition Level Transition countries generally lack well-developed, low-cost financial markets where firms can raise funds through corporate bond and equity offerings. Instead, firms mostly rely on bank loans and retained earnings for their funding needs. Adams and Amel (2005) suggest that the bank lending channel is most important in countries where borrowers have limited alternatives to bank loans as sources of funding. In a country with well-functioning financial markets firms that are affected from the monetary policy tightening or credit crunch in bank lending markets can reduce their demands for bank loans and switch to equity and bond markets if needed. In this section we examine whether the impact of bank competition on the bank lending channel varies depending on the degree of financial market development. We measure the level of financial sector development by the inclusion of a country in MSCI Emerging and Frontier indices. Specifically, we separate countries into three groups Emerging and Frontier markets based on their inclusion in the MSCI classification of financial markets and Other that consists of countries that are not included in any of these market segments. We report our results in Table 7. We find that the coefficient of the PRH statistic is significant and positive for the bank loan growth in Frontier and Other countries, and the coefficient of Transition index is negative in Emerging countries. These results suggest that high bank competition is associated with an increase (decrease) in the growth rate of bank loans 20
in countries with less (more) developed financial markets. It is possible that an increase in bank competition stimulates loan demand and supply factors in less-developed financial markets by increasing cost efficiency, expanding the client base and offering different services. Our results also show that the interaction terms between the monetary policy rate and bank competition variables are negative and significant for the bank loan growth in Frontier and Other countries. Thus an increase in bank competition is likely to strengthen the bank lending channel of the monetary policy transmission in countries with less-developed financial markets. It is possible that an increase in bank competition is often caused by increased market share of small banks that are still more affected from monetary policies. However, in Emerging countries both banks and firms are more able to insulate themselves from the monetary policy shocks by accessing funding sources other than the bank loans. 4. Conclusions Prior studies analyze the impact of bank competition on the transmission of monetary policy through the bank lending channel in developed and selected developing countries. None of these studies examine this effect in transition countries that structurally differ from both developed and other developing countries. Our study aims to fill this gap by using bank-level balance sheet and income statement data to examine the relationship between bank competition and the bank lending channel in 29 transition countries during the period from 1996 to 2011. We use the interaction of the monetary policy rate with two measures of bank competition PRH statistic estimated from bank-level variables for each country and Transition index obtained from EBRD, as key explanatory variables of the effectiveness of the bank lending channel. 21
We find that an increase in bank competition strengthens the bank lending channel and the effectiveness of monetary policy in transition countries. This is especially evident for high liquidity, high capitalization, and high profitability banks. An increase in bank competition may stem from the increased market share of small banks that are more vulnerable to the monetary policy shocks. When we separate the impacts of bank competition among small and large banks, we find that high competition among small banks strengthens the bank lending channel, while that among large banks does not have a significant effect. When we analyze the asymmetric monetary policies, we find evidence that high bank competition strengthens the effectiveness of monetary policy shocks during the periods of both monetary tightening and monetary expansion policies. In a monetary policy tightening high bank competition strengthens the impacts of monetary policy shocks and is associated with a decrease in the growth rate of bank loans. Consistently, high bank competition also strengthens the impacts of monetary policy expansion and is associated with an increase in bank loan growth. Our regional analysis indicates that high bank competition in all regions strengthens the bank lending channel and the impacts of monetary policy shocks on bank lending growth. When we analyze the impact of financial sector development, we find that an increase in bank competition is likely to strengthen the bank lending channel of the monetary policy transmission in countries with less-developed financial markets. We also find that the growth rate of bank loans in countries with less (more) developed financial markets is positively (negatively) related to high bank competition. Overall, our results provide evidence that the relationship between market structure in banking and the monetary policies differs from other developing countries. Regulators in transition countries can focus on specific developments in the market structure and can 22
implement certain reforms to increase the level competition in the banking market. This way central banks can increase the effectiveness of the monetary policies through the bank lending channel. 23
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Table 1: Sample Description by Country 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total Armenia 2 4 5 4 5 5 8 9 10 17 21 22 22 21 20 17 192 Azerbaijan 2 3 4 4 7 8 11 14 16 18 21 21 22 22 22 13 208 Georgia 0 0 5 7 9 8 10 10 10 11 10 13 14 14 12 10 143 Turkey 18 21 22 32 27 31 37 38 49 59 84 89 92 95 92 73 859 Caucasus 22 28 36 47 48 52 66 71 85 105 136 145 150 152 146 113 1402 Albania 0 0 1 3 2 2 5 7 7 7 8 13 10 11 11 6 93 Bosnia 0 0 0 0 0 0 0 0 12 17 18 20 22 22 21 18 150 Bulgaria 0 1 1 1 1 2 14 20 23 26 26 27 31 30 30 21 254 Macedonia 9 8 7 8 10 9 12 10 11 12 14 16 15 14 13 10 178 Moldova 5 5 6 7 9 12 11 14 18 18 16 18 20 18 17 14 208 Montenegro 0 0 0 0 0 0 4 6 7 7 7 9 9 8 7 6 70 Romania 4 4 11 16 20 21 28 29 33 35 32 29 28 27 25 20 362 Serbia 0 0 0 0 1 1 2 17 30 34 35 35 36 37 35 30 292 Southeast Europe 18 18 26 35 42 47 76 103 141 156 156 167 171 167 159 125 1607 Belarus 1 1 2 6 6 11 10 11 13 13 14 17 17 17 16 7 162 Croatia 30 37 35 37 40 40 38 36 34 35 38 37 40 40 41 37 595 Czech Republic 25 26 22 23 22 25 25 29 41 36 32 31 32 35 35 10 449 Estonia 12 13 8 8 10 11 13 11 11 12 11 12 8 9 9 6 164 Hungary 20 22 18 22 28 31 33 36 34 36 33 33 35 31 28 18 458 Latvia 9 13 17 19 18 17 22 23 27 33 34 35 34 32 28 22 383 Lithuania 10 11 11 13 15 14 14 15 15 16 18 18 18 18 18 16 240 Poland 32 36 40 41 44 37 39 38 54 44 40 40 43 46 43 32 649 Slovakia 13 17 17 18 21 18 20 21 20 27 19 22 23 22 20 18 316 Slovenia 15 16 17 19 20 20 20 20 21 27 24 25 29 31 27 26 357 Ukraine 7 9 15 23 31 35 37 44 43 48 57 58 55 54 50 28 594 Central and Eastern Europe 174 201 202 229 255 259 271 284 313 327 320 328 334 335 315 220 4367 Kazakhstan 3 10 14 8 13 14 19 25 27 25 23 27 27 24 24 20 303 Kyrgyzstan 0 0 0 0 1 1 2 2 2 5 5 4 4 4 4 2 36 Russia 26 28 16 43 70 82 93 126 151 164 166 170 163 154 134 87 1673 26
Tajikistan 0 0 0 0 0 0 0 2 3 4 4 4 4 3 3 1 28 Turkmenistan 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 13 Uzbekistan 1 3 3 4 5 7 7 10 9 12 10 9 11 10 10 8 119 Central Asia 30 41 33 56 90 105 122 166 193 211 209 215 210 196 176 119 2172 TOTAL 244 288 297 367 435 463 535 624 732 799 821 855 865 850 796 577 9548 27