Competing over Competition
Civitas, 6 September 2010
One important result of the financial crisis that began in mid-2007 is the immense proliferation of political debate about subjects that were previously seen as niche or specialist, writes Stephen Clarke. This is undoubtedly a good thing, the less opaque a subject is, the more people can be party to discussions about it.
Competition in the banking sector is one such issue which has received a great deal of coverage lately. However two recent reports released on banking competition seem to be at loggerheads; on 17th August the Telegraph reported on a study undertaken by the US Federal Reserve which argued that increased banking competition in the US has led to more lending for small and medium sized businesses (SMEs). In contrast on 22nd August the Financial Times reported on a study by Bain & Company, the consulting firm, which, looking at the banking sectors of 30 countries, argued that there was no additional benefit of having more than 4 or 5 big competitors in any one market. Where does this debate leave the UK?
The UK’s banking system has been subject to calls for greater competition since the crisis revealed some of the failings of the current system. Chancellor George Osborne speaking at the Bloomberg Financial News Service in August said that he attached ‘a very high priority’ to getting banks lending more, seeing more competition as one way to do this. Furthermore recent developments in the banking system itself suggest that increased competition may soon be a reality; the opening of ‘Metro Bank’ in July 2010 and the entrance into the market of newcomers such as Aldermore lends weight to the conclusion that the UK’s banking market may soon witness greater competition. Where does this leave the problem of lending to SMEs?
There is no doubt that lending to small businesses has decreased since the financial turmoil began. IGF’s ‘Small Business Survey 2010’ reported that 1 in 3 SMEs experienced cash-flow problems and 1 in 3 of those that did experience problems nearly went out of business. Furthermore the bank Aldermore reported that complaints from SMEs about bank loans has gone up 119% in the last 12 months. This suggests that there may be some truth in claims that the banking system is currently failing to lend to SMEs (many banks question this view however and argue that credit is available but that SMEs are not requesting it). Putting this argument to one side for a moment, the question remains; will greater competition solve the problem of lending to SMEs?
There is a great degree of academic debate about the role of competition in improving the lending prospects for SMEs, in many cases academics (like the studies mentioned above) seem to be at loggerheads over the issue. However, a study by Elsas (Empirical determinants of relationship lending, 2005) points to some of the problems without coming to absolute conclusions concerning competition and lending to SMEs . Elsas argues that when analysing the effect of competition it is important to examine the state of competition in the market beforehand. Looking at relationship lending to SMEs in Germany he produces the counter-intuitive argument that in some cases a highly concentrated market (with low competition) can increase the amount of close relationship lending between banks and SMEs. This is because the banks, released from the financial constraints imposed by competition, can develop close lending relationships with SMEs, knowing that SMEs cannot ‘shop around’ to a great degree. In contrast, and seemingly against the same logic, Elsas highlights how concentration can have the opposite effect in a low or medium concentrated market, in this situation an increase in concentration can reduce the amount of close relationship lending with SMEs because the banks who, now in a position with a median, rather than a high, degree of competition, would rather not develop close relationship lending with SMEs because in this case the costs outweigh the gains. In a situation of high competition the benefits of relationship lending outweigh the costs because banks need to develop close lending relationship to shield themselves from the effects of price competition. Elsas represents his evidence in a ‘U’ shaped graph and the effect that competition will have on relationship lending to SMEs changes with the position that a country is on the graph. For instance, on the top of the first ‘U’ point, a country has a low degree of banking concentration and a high degree of relationship lending, but as banking concentration increases relationship lending decreases until the country begins to climb the other side of the ‘U’ and at this point an increase in banking concentration actually results in an increase in relationship lending.
Elsas’ analysis is complex, but it draws attention to the fact that two forces are at work and that which is more important depends on the state of the banking system when competition is introduced. In this sense it may be a mistake for the British Government to be ‘pro’ or ‘anti’ competition without first taking a detailed look at the present and perhaps future state of the British banking system. Such close analysis is necessary when implementing any changes in a complex system, and serves as a necessary reminder that although previously opaque topics may be becoming clearer, detailed, specifically-tailored, analysis is still the most valuable way to approach any policy decision.