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This study focuses on the level of competition and market power in the Indian banking industry. Using an unbalanced panel for 15 years from 1992-2006, we find that Indian banking industry is characterized by a relatively higher degree of competition compared to that of its counterparts particularly in the European countries. The average mark-up over marginal cost has been 10% during the study period. We also find that the foreign banks charged nearly twice the mark-up as compared to that charged by Public and Domestic Private Banks. Further, the average mark-up level is found to decline substantially from 20% at the beginning of reforms to 5% in 2006, reflecting a sharp decline in market power with the banks during the period under consideration.
Historically, a perfect competition has been viewed as the most desirable market structure in view of its welfare implications. Perfect competition has always been associated with minimum prices and allocative efficiency. However, things have been different with regard to the financial sector. For long it was believed that some degree of market power was necessary to maintain stability and growth in the banking sector. The general view was that in an oligopolistic environment banks could enjoy extra profits which would foster the stability of the individual banks and banking system as a whole. In such a situation individual banks could absorb losses more easily and the banking industry would always have sufficient funds to rescue an ailing member (Padoa-Schioppa, 2001).
However, this view has changed considerably in recent times. In fact, much of the recent public debate seems to assume that perfect competition is an ideal market structure for banking industry (Northcott, 2004). A number of arguments, mainly derived from traditional industrial organization theory, have been advanced in literature to propound the importance of healthy competition in the financial sector. A number of researchers advocate that, as in other industries, in financial sector too the degree of competition can promote efficiency in the production of financial services, the quality of financial products and the rate of innovation (Claessens and Leaven, 2004). Higher level of competition in the financial sector has also been associated with higher growth rate of economy (Guzman, 2000). Further, a number of studiese.g., Koskela and Stenbecka (2000); and Boyd et al. (2004) have argued that a higher level of competition can lead to greater stability and a decrease in the fragility of the financial sector. In the light of such arguments, a number of developing economies have liberalized their banking sector in the last two decades of the 20th century. Government of India also followed suit and in the beginning of the 1990s introduced massive liberalization measures in the financial sector in order to promote efficiency in intermediation with the ultimate objective of improving the overall allocative efficiency of resources (Reddy, 2006). |
