BANKING MARKET STRUCTURE, REGULATIONS, AND STABILITY IN THE INDIAN SUBCONTINENT

Abstract

The global financial crisis (GFC) of 2007-09 disrupted the smooth functioning of financial systems across the globe. An analysis of the GFC and its repercussions revealed that the banking sector was at the centre of this crisis. As observed, it had a direct effect on western countries; however, the rest of the world was not entirely isolated. In emerging economies, the indirect spillover effects were observed through the real sector. Similar effects were also seen in the Indian subcontinent; however, it was subdued due to the limited global exposure of these economies. Over the past decade, the exposure of these economies to the rest of the world has grown. In addition, the complexity in their banking sectors has also magnified due to innovations, creation of new financial instruments, consolidation, financial integration, and globalisation. These changes might have altered the market structure of the banking systems in the Indian subcontinent. Moreover, the increased dependence of these economies mainly on the commercial banking industry for their financial requirements, primarily perhaps due to the less prominence of the other segments, aggravated concerns about banking stability among policymakers. Therefore, regulators stepped up sound regulatory efforts to strengthen banking systems and make them more resilient to unprecedented occurrences like that of the GFC and, more recently, the COVID-19 pandemic. In light of the above, it is imperative to comprehend the banking sector developments that could cause this sector to become fragile. This thesis thus examines the market structure, competition, regulations, and stability in the banking systems of four major economies in the Indian subcontinent, i.e., India, Nepal, Bangladesh, and Pakistan. The investigation covers the years from 2004 to 2018, which subsume both the pre-and post-GFC periods. The broader objectives of the thesis are as follows. Firstly, the thesis aims to investigate the banking market structure and competition in the sampled countries. In order to accomplish this objective, the study relies on a three-pronged approach and assesses competition using structural, non-structural and regulatory approaches. For measuring market structure, the study employs the concentration ratio (CR3 and CR5) and the Hirschman-Herfindahl index (HHI) of total assets and total bank deposits. The bank competition is assessed using the dynamic version of the non-structural Panzar-Rosse (P-R) approach. The study makes an estimation of the degree of competition in both interest-bearing and aggregate banking markets of sampled countries. Second, the thesis demystifies the bank regulations that govern the level of competition in the sampled countries. In order to realise this objective, the investigation dwells on the methodological framework of Barth et al. (2013) and builds the regulatory indices on the key regulators pertaining to activity restrictions, conglomerate formation, entry norms, resolution measures and independence of bank supervisors in the region. Finally, this thesis examines the evolution of bank stability and its determinants in the sampled countries of the Indian subcontinent. The objective is to create a composite PCA-weighted index-based measure of bank stability on five distinct dimensions - capital adequacy, asset quality, management efficiency, earnings, and liquidity. The study investigates both non-threshold and threshold effects of bank-specific, industry-specific, macroeconomic, regulatory, and institutional determinants of bank stability. For empirical estimation of determinants of bank stability, the study relies on a dynamic panel two-step system Generalised Method of Moments approach and panel threshold method. The thesis draws several intriguing findings. The banking industries of Nepal, Bangladesh, and Pakistan have experienced continuous deterioration in the assets and deposit concentration during the study period. However, there has been an increase in bank concentration in India in the second half of the study period. The econometric estimation based on the dynamic P-R model divulges that although the banking industries of the sampled countries are generally in the long-run market equilibrium, there have been a few episodes of long-run market disequilibrium. Additionally, the countries encountered varying degrees of bank competition during the study period. The investigation of the structure-conduct relationship divulges a direct relationship between bank concentration and competition in the sampled countries. The investigation of the bank regulations that affect competitive conditions reveals that the activity and conglomeration restrictiveness has grown over time in the Indian subcontinent, especially in the aftermath of the GFC. The entry requirements for the banking business have been made more stringent to allow only “fit and proper” applicants to commence the banking business. The share of government-controlled banks has declined, and the restructuring powers of the supervisory authorities in India and Nepal have improved significantly. Except for Pakistan, banks now act more promptly to take corrective actions for distressed banks in all sampled countries. On the stability aspects, the empirical findings demonstrate that the banking systems in India, Nepal, and Bangladesh experienced a jerk in their stability levels, especially post-2013. Further, a jolt to stability continued to persist for some time, and the recovery was not instantaneous but partial. Among bank-specific determinants, bank size appears to influence the stability of Indian banks positively. This outcome thus supports the ongoing wave of consolidation in the Indian banking industry, which is expected to have some positive implications for the stability of the banks. This relationship is unfavourable for Bangladeshi and Pakistani banks, suggesting the prevalence of the “too big to fail” notion. Credit growth has a negative impact on bank stability in Nepal and a positive impact on the stability of Pakistani banks. The research backs the “diversification-stability” hypothesis for the Nepalese banking industry. Further, we note that inflation has a detrimental effect on bank stability in all countries, while sound “institutional quality” strengthens the stability of banks in India and Nepal. An investigation of regulatory variables divulges that entry restrictiveness, government ownership and independence of supervisory authority are the significant determinants of bank stability. The threshold analysis validates the existence of a bank size threshold, suggesting that the impact of bank size on stability varies across pre-and post-threshold regimes. The impact of ROA is stronger in the post-threshold regime, and inefficiency has a detrimental influence on bank stability in both regimes. The results are consistent across alternative panel models and measures of bank stability. The thesis provides some important policy implications for regulators and policymakers in the region. An investigation of the bank market structure highlights that policymakers need to stay watchful about the declining degree of competition as it can undermine efficiency by encouraging monopolistic behaviour. Assessment of the bank stability put forward that regulatory authorities must be vigilant if stability wanes in response to internal or external shocks, as any adverse impact might not moderate instantaneously and can last for a long time. The results of this thesis validate the presence of the “too big to fail” notion among banks in Bangladesh and Pakistan. Therefore, these countries’ regulatory authorities must maintain vigilance over large banks’ excessive risk-taking and lending processes. Inflation is a critical factor adversely impacting bank stability in the region. Hence, the study recommends that the central banks of these countries, in consultation with the governments, should hold anticipation about the inflation stability trade-off. Finally, some bank-specific variables, such as bank size, ROA, and credit growth, have significant threshold impacts on bank stability in the Indian subcontinent. Therefore, regulatory authorities must consider the non-linear nature of the relationship while drafting bank regulations in this regard.