Lack of competition in the banking sector has detrimental effects. Studies have found that it can result in higher prices for financial products and less access to finance, especially for smaller firms. Others have shown that it can lead to the entry of fewer new firms, less growth for younger firms, and delayed exit for older firms. Moreover, while a debate is still under way, new evidence suggests that lack of competition can undermine the stability of the banking sector, especially if some banks become too big to fail.
How to measure bank competition? In a recent paper  Asli Demirgüç-Kunt and I propose a multipronged approach. While we apply this framework to Jordan, it can be used to analyze bank competition in any country. In fact, the approach developed in this paper has been used to analyze competition in China, the Middle East and North Africa, and Russia.
We argue that there are several useful metrics to analyze bank competition. Measures of market concentration, such as the share of assets held by the top 3 to 5 banks or the Herfindahl index (another measure of market structure), are commonly used as indicators of competition based on the Structure-Conduct-Performance paradigm. This paradigm postulates that where there are fewer and larger firms, the firms are more likely to engage in anticompetitive behavior and reap large benefits. While we think that market concentration is an acceptable place to start in analyzing competition, we caution against using this as the only measure. Studies have shown that concentration is not the same as competition and that even very concentrated markets can remain competitive if they are contestable—that is, if barriers to the entry and exit of banks are low. If the banking sector is contestable, incumbent firms will feel pressure to compete.
Assessing contestability requires looking into the licensing procedures and practices, the capital requirements, and the regulations affecting entry into banking. As part of evaluating contestability, we also suggest examining the framework for bank exit. We argue that an analysis of bank prices and spreads, as disaggregated as possible (such as by product type or market segment), is also useful because it can point to inefficiencies in the banking sector that might be symptomatic of lack of competition.
Finally, we suggest using nonstructural measures of competition such as the Panzar and Rosse H-statistic and the Lerner index. The advantage of these measures is that they infer the degree of competition from the observed behavior of banks. The H-statistic infers competitive behavior or market type from the elasticity of revenue to input prices—that is, how sensitive revenue is to changes in firms’ costs. In general, higher numbers for the H-statistic indicate higher levels of competition (with a negative value or 0 indicating a monopoly and 1 indicating perfect competition). The Lerner index directly measures pricing power by examining the price markup over marginal cost (that is, the extra cost of producing an additional unit of output). Higher values for this index indicate greater market power and lower levels of bank competition.
Because of the potentially damaging consequences of lack of competition in the banking sector, measuring the level of competition is important. We strongly recommend that policy makers in developing countries go beyond monitoring bank concentration and consider other metrics discussed here to obtain a more informative diagnosis of competition in banking.
Demirgüç-Kunt, Asli, and Maria S. Martinez Peria. Forthcoming. “A Framework for Analyzing Competition in the Banking Sector: An Application to the Case of Jordan .” Policy Research Working Paper, World Bank, Washington, DC.
Anzoategui, Diego, Maria S. Martinez Peria, and Roberto Rocha. 2010. “Bank Competition in the Middle East and Northern Africa Region.” Policy Research Working Paper 5363, World Bank, Washington, DC.
Anzoategui, Diego, Maria S. Martinez Peria, and Martin Melecky. 2010. “Banking Sector Competition in Russia.” Policy Research Working Paper 5449, World Bank, Washington, DC.