Market power, Stability, and Performance in Islamic Banks of Pakistan

RESEARCH PROPOSAL

Introduction

Islamic banking refers to the type of banking activity that is in accordance to the

principles laid down by Shari’ah. Another name used for such type of banking is

“Shari’ah Compliant Finance”. The practical application of these banking and financing

activities is done through the development of Islamic economics. Islamic banking is

different than the conventional banking’s philosophies, practices and features. Five such

religious features can be obtained from the literature (Lewis and Algaoud, 2001). They

are:

1. “Riba” (usury) is prohibited in all its forms

2. Business should be undertaken only for “halal” (legal, permitted) activities

3. “Maysir” (gambling) is prohibited and all the transactions should be free from

“gharar” (speculation)

4. “Zakat” (charity) is to be paid by the banks to benefit the society

5. All activities of the bank must be in accordance with Islamic rules, principles, and

norms and a Shari’ah Supervisory Board must supervise and advise the bank on

its activities

The establishment of Islamic banking and the application of these rules and principles to

private and semi-private commercial institutions in Muslim countries can be traced back

to late 20th century. Although the efforts for the Islamization of banking sector in

Pakistan started a couple of decades ago, it was only in 2002 that the first full-fledge

Islamic bank, Meezan Bank Limited started its operations in Pakistan. Therefore, Islamic

banks are still quite new entrants in the banking industry of Pakistan.

This study will specifically deal with the market power, stability and performance of

Islamic banks in the recent unstable socio-political and a deteriorating economic

environment of Pakistan. Market power can be defined as the ability of a firm; in this

case a bank; to raise the prices of goods and services in excess of marginal cost and the

long-run average cost, thus, making economic profits. The firms having market power are

called “price makers” while those without it are called “price takers”. Another aspect of

the study is stability, which can be referred to as a state where the firm’s income

constantly grows and the firm does not go in to loss. Both of these factors, market power

and stability, will in turn be the indicators for the overall performance of the firm (bank,

in this study).

An essential feature of Islamic banking is that it is interest-free. But there is more to

Islamic banking than just being interest-free banking. It contributes towards a more

equitable distribution of wealth and income. The aim of this study is to judge the market

power, stability and performance of Islamic banks in Pakistan. There is little or no work

done earlier in this regard. Therefore, this study will contribute to the generation of

knowledge in this area as well as the results can be fruitful and used by the managers of

Islamic banks in particular and financial analysts in general.

Literature Review

Although it is hard to find any literature on market power of Islamic banks, a lot of

studies have been undertaken about the market power of banking industry. The Panzar-

Rosse H statistic has been used in various studies to evaluate bank competition in

different regions of the world. One such study was undertaken to analyze bank

completion in United States, Italy, Germany and France for a period of four years (1992-

1996). The results showed that large banks in these countries were in a state of

monopolistic competition while small banks were in a state of monopoly (De Bandt and

Davis, 2000).

Perera et al. (2006) examined the competition in South Asian banks over the period 1995-

2003. This study revealed that competition in the traditional interest-based product

market is greater in Bangladesh and Pakistan, while the fee-based product market in India

and Sri Lanka is more competitive.

Yet another study assessed the competition in banking industry in twenty-three countries.

The sample showed monopolistic competition (Bikker and Half, 2002). A handful of

studies have dealt with competition in Chinese banking sector. Yuan (2006) analyzed the

competitive condition of the Chinese banking industry over the period 1996-2000. The

results suggested that China's banking sector was already near a state of perfect

competition (that is, before foreign banks began to enter China’s financial market).

A similar study to assess the competition in banking sector of Pakistan was conducted for

a sample of twenty-six banks from 1997 to 2007. Various tests on PR-H Statistics suggest

that banking sector of Pakistan, as a whole, is consistent with a monopolistically

competitive market structure (Khan, 2009).

The different competitive conditions found by these different studies are partly accounted

for by the fact that different researchers have used different reduced revenue equations to

measure competition. Further, the different results are closely linked with the banking

sector reforms over the specific period investigated and the banking regulations of a

particular country/ region.

Privatization of all national banks except one, capital strengthening, corporate

governance, liberalization of foreign exchange regime, consumer financing and the likes

are some of the banking reforms introduced by the State Bank of Pakistan which have

allowed the banks to operate in more freedom which have substantially led to the

increased competition among commercial banks of Pakistan. Legal difficulties and time

delays in recovery of defaulted loans have been removed through a new ordinance, The

Financial Institutions (Recovery of Finances) Ordinance, 200 1 (Husain. I, 2004).

Pakistan has allowed Islamic banking system to operate in parallel with the conventional

banking providing a choice to the consumers. Several full-fledged Islamic banks have

already opened the doors for business and many conventional banks have branches

exclusively dedicated to Islamic banking products and services. These factors have

further intensified the competition in banking industry of Pakistan (Husain. I, 2004).

Other empirical studies attempted to determine the determinants of market power in

banking industry. Fungacova et al. (2010) used Lerner’s Index to measure the market

power of Russian banks. The period of sample was 2001-2007. They arrived at the

conclusion that competition in banking industry has slightly improved over the period

under study. Furthermore, the findings suggested that bank size, risk and market

concentration are significantly related to the market power of Russian banks.

The market power of the Spanish banking industry over the period 1986-2002 was

investigated by Fernandez de Guevara and Maudos (2007). The results showed an

increase in market power from the mid-1990s. An empirical research attempted at

assessing the increase/decrease in market power of Chinese banks with the increase in

risk-taking behavior suggested that Chinese banks with higher volumes of non-traditional

activities have lower market power, while the technical efficiency improvement of

Chinese banks increases their market power (Tan and Floros, 2013).

Hypothesis/ Research Question

In this study, we will attempt to understand the joint effect of technical efficiency and

risk on the market power of Islamic banks of Pakistan. Our study will be mainly

concerned with the following hypotheses:

“Do Islamic banks in Pakistan hold market power?”

“Will assuming more risk result in greater market power?”

Methodology

Estimation of Banks’ Market Power

Modern industrial organizations’ suggests the following methods to measure the market

power:

1. The Lerner’s Index

2. The Breshnahan mark-up Test

3. The Panzar-Rosse H Statistic

We will also use the concentration ratio to measure the competition in Islamic banks of

Pakistan.

The Lerner index represents the extent to which a particular bank has market power to set

price above marginal cost (Tan and Floros, 2013). The Lerner’s Index is easy to calculate

for each bank and for each year based on annual bank-level variables. The price will be

computed as a ratio of total assets to total revenues. The total cost will be calculated on

the basis of total assets, prices of labor, capital and funds. Then this cost will be used to

determine the marginal cost (ratio of total cost to total assets). Once these computations

are done, it is easy to calculate Lerner’s index as:

This index will be a direct measure of the competition of bank.

Impact of risk on market power of Islamic banks

In order to study the impact of risk on market power of Islamic banks, we will run a

regression for Lerner’s index (Y) as a dependent variable and risk (X1), industry (X2),

macro (X3) as independent variables.

R = α˳ + α Risk + β industry + γ macro + ε

Here, R is the Lerner’s index. Risk will be obtained by the ratio of total loss to total

deposits. Industry represents the industry-specific variable (concentration and stock

market capitalization, in this case) while macro represents the macro-economic variables

like inflation and GDP growth.

Data description

Data will be composed of annual data for at least 20 Islamic banks of Pakistan over a

period of 2006 to 2010.

Scope

This research will focus on assessing the market power of Islamic banks operating in

Pakistan. This study will try to measure the market power of Islamic banks that are facing

more risk as compared to the conventional banks. In past there has been very little

exploration of this aspect of banking industry of Pakistan. Even if some work is already

done, it is mainly about the banking sector in general. We have a parallel banking system

in Pakistan, therefore it is important to understand both types of banks separately.

Limitations

Currently there are five full-fledge Islamic banks in Pakistan with their branch network

expanded across the country. Some conventional banks also have “Islamic Banking

Windows” operating in some of their branches. Therefore, the only limitation of this

study will be the small number of Islamic banks currently operating in Pakistan.

Expected benefits

This study will add to the body of existing knowledge about market power of banks and

competition in banks.

The results of this study can be replicated in conventional banks in Pakistan and in

Islamic banks of other countries.

The results obtained from this research can be equally used by the bank managers of both

Islamic and conventional banks.

The results and conclusions can also be used by the financial analysts.

References

Algaoud L and Lewis M (2001) ‘Islamic critique of conventional financing’

Bikker J A and Haaf K (2002) ‘Competition, concentration and their relationship: an

empirical analysis of the banking industry’, Journal of Banking and Finance, 26,

2191–2214

De Bandt O and Davis E P (2000) ‘Competition, contestability and market structure in

European banking sectors on the eve of EMU’, Journal of Banking and Finance, 24,

1045-2066

Fernandez de Guevara J, Maudos J and Perez F (2007) ‘Integration and competition in

the European financial markets’, Journal of International Money and Finance, 26, 26-35

Fungacova Z, Solanko L and Weill L (2010) ‘Market Power in the Russian Banking

Industry’, Universite de Strasbourg, Working Paper no. 09

Husain I (2004), ‘Banking sector reforms in Pakistan’, SBP Research Bulletin

Khan M (2009) ‘An analysis of degree of competition in banking sector of Pakistan

through a direct measure of market contestability’, SBP Research Bulletin, Vol. 5

Perera S, Skully M and Wichramanayake J (2006) ‘Competition and structure of South

Asian banking: a revenue behavior approach’, Applied Financial Economics, 16, 789-801

Tan Y and Floros C (2013), ‘Market power, stability and performance in the Chinese

banking industry’, Economic Issues, Vol. 18, Part 2, 2013

Yuan Y (2006) ‘The state of competition of Chinese banking industry’, Journal of Asian

Economics, 17, 519–534.Economic Issues, Vol. 18, Part 2, 2013