Rethinking the nexus between competition and efficiency in emerging economies: Evidence from Sri Lankan banking sector

This study provides new and rather scarce evidence of effects of bank competition on banking sector efficiency in an emerging economy during the period 1996-2010. Using bank level accounting data and applying Panzar-Rosse approach the study finds that Sri Lankan banking market is moderately competitive. Further, by using non parametric (DEA) approach study revealed a moderate level efficiency of Sri Lankan banking sector. The econometric analysis carried out in this paper provides evidence for a U shape relationship between bank competition and efficiency. The moderate level of efficiency of the banking sector is attributed to the moderate level of competition in Sri Lankan banking industry. Moreover, the results of the analysis confirm the long run positive effect of competition on efficiency in the banking sector. found that loan rates decrease and deposit rates increase as more banks are added to the market. With respect to the level of bank interest rates, Maudos and Guevara (2004) show that an increase in banks‟ market power (i.e. a reduction in competitive pressure) results in higher net interest margins. Leuvensteijn et al (2008) extends the existing empirical literature and analyze the effects of loan market competition on bank interest rates on loans and deposits, measuring competition by the Boone indicator. Their results show that, in the euro area countries, bank interest rate spreads on mortgage loans, consumer loans and short-term loans to enterprises are significantly lower in more competitive markets. This result implies that bank loan rates tend to be lower under heavier competition, thus improving social welfare. Further, banks compensate for stronger loan market competition by lowering their deposit rates. These results show that stronger loan market competition reduces bank loan rates while changes in market rates are transmitted more rapidly to bank rates. implications of bank competition. Empirical research attempts to detect the effects of bank competition on lending to different groups of borrowers, and in particular, to privately held firms. Privately held firms are usually smaller than publicly held firms, and are characterized by larger informational asymmetries and greater dependence on bank financing for their investments. Allocative efficiency of bank competition can be reached when the supply of credit is provided to the most productive projects first. Supporting the Peterson and Rajan (1995) argument, Shaffer (1998), cited earlier, also finds evidence of higher loan charge-off rates in Metropolitan Statistical areas with a higher number of banks. He further shows that the average quality of a bank`s pool of borrowers declines as the number of competitors in the market increases. Zarutskie (2005) examines the impact of bank competition on the borrowing and investment of a large sample of privately held firms in the U.S. His findings reveal that newly formed firms, i.e., those likely characterized by the largest informational asymmetries, have significantly less outside debt on their balance sheets in the more competitive banking markets following deregulation. These firms substitute more contributed equity capital for outside debt, although they are not enough to invest as they would have in less competitive banking markets.