The objective of this paper is to analyze the banking market structure and its implications for competition policy using the contestable market hypothesis. In addition to providing empirical evidence on the contestable market theory for a developing country in Africa, this paper provides a basis for an informed financial policy in the context of the financial sector. Using the reduced form Rosse-Panzar methodology, we find empirical evidence that the banking industry is not contestable which reinforces the view of its monopolistic nature. Hence, the empirical results vindicates the rationale for diversification of the financial system in order to increase competition, reduce concentration and enhance consumer welfare.

Competition in the banking industry has motivated a lot of research in both developed and increasingly, in developing countries implementing financial deregulatory reforms. Likewise, many developing countries, e.g., Mauritius, have a heavily concentrated banking sector, which has often led to hypothesize that its banking industry is uncompetitive. The objective of this paper is to analyze the banking market structure and its implications for competition using the contestable market hypothesis. In addition to providing empirical evidence on the contestable market theory for a developing country in Africa, this paper provides a basis for an informed financial policy in the context of the financial sector. The rest of the paper is structured as follows: Section 2 gives an account of the structure and reform in the Mauritian banking industry; Section 3 reviews previous literature on contestable banking market, Section 4 deals with the methodology, data and the results and Section 5 concludes the paper and provides the main policy implications.

The Contestable Market Theory (CMT), first developed by Baumol (1982), stresses that a concentrated industry can behave like a competitive market if the barriers for new entrants to the market are nonexistent or low. CMT assumes that firms can enter or leave rapidly any market without loosing their capital and that potential competitors have the same cost function as incumbent firms. Baumol emphasizes that incumbent firms are always vulnerable to hit-and-run entry when they try to exercise their potential market power. These features of contestable markets imply that a concentrated banking market can be effectively competitive even if it is dominated by a handful of large banks. The absence of sunk costs implies that banks can leave the market with their capital invested to be used elsewhere. The outcome ofa perfect contestable market will be that of perfect competition. The price level in the market equals marginal costs of production and welfare is guaranteed.