Competition and efficiency in the mexican banking industry theory and empirical evidence

COMPETITION and
EFFICIENCY in the MEXICAN
BANKING INDUSTRY
Theory and Empirical Evidence

SARA G. CASTELLANOS,
GUSTAVO A. DEL ÁNGEL
& JESÚS G. GARZA-GARCÍA


Competition and Efficiency in
the Mexican Banking Industry


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Competition and Efficiency in
the Mexican Banking Industry
Theory and Empirical Evidence

Sara G. Castellanos, Gustavo A. Del Ángel,
and Jesús G. Garza-García

Palgrave

macmillan


COMPETITION AND EFFICIENCY IN THE MEXICAN BANKING INDUSTRY

Copyright © Sara G. Castellanos, Gustavo A. Del Ángel, and Jesús G.
Garza-García 2016
Softcover reprint of the hardcover 1st edition 2016 978-1-137-46528-3
All rights reserved. No reproduction, copy or transmission of this publication
may be made without written permission. No portion of this publication
may be reproduced, copied or transmitted save with written permission. In
accordance with the provisions of the Copyright, Designs and Patents Act
1988, or under the terms of any licence permitting limited copying issued by
the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London
EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
First published 2016 by
PALGRAVE MACMILLAN
The authors have asserted their rights to be identified as the authors of this
work in accordance with the Copyright, Designs and Patents Act 1988.
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire, RG21 6XS.
Palgrave Macmillan in the US is a division of Nature America, Inc., One
New York Plaza, Suite 4500, New York, NY 10004-1562.
Palgrave Macmillan is the global academic imprint of the above companies
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ISBN 978-1-349-55677-9
E-PDF ISBN: 978–1–137–51841–5
DOI: 10.1057/9781137518415

Library of Congress Cataloging-in-Publication Data
Castellanos, Sara G. (Sara Gabriela), 1968–

Competition and efficiency in the Mexican banking industry : theory
and empirical evidence / by Sara G. Castellanos, Gustavo A. Del Ángel and
Jesús G. Garza-García.
pages cm
Includes bibliographical references and index.
1. Banks and banking—Mexico. 2. Competition. I. Angel, Gustavo A. del.
II. Garza-García, Jesús Gustavo. III. Title.
HG2714.C37 2015
332.10972—dc23

2015019818

A catalogue record for the book is available from the British Library.


To our beloved families and friends with love and gratitude.
SGC, GD, JGGG


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CONTENTS

List of Figures and Tables

ix

Preface and Acknowledgments

xi

1. Introduction

1

2. Literature Review of Banking Studies

9

3. Structural Evolution and Cycles of Consolidation

37

4. Competition in the Mexican Banking System: A Review

71

5. Analysis of Competition and Efficiency in the Mexican
Banking Sector

85

6. Competition Policy in the Mexican Financial System

125

7. Conclusions

159

Notes

165

References

173

Index

189


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FIGURES AND TABLES

Figures
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
5.1

5.2
5.3
5.4
5.5
5.6
5.7
6.1
6.2

Bank assets on GDP
Four-firm concentration ratio 1970–1980
HHI Index 1970–1980
Four-firm concentration ratio on assets 1982–1988
Commercial banks assets on GDP 1983–1992
Four-firm concentration ratio on assets 1988–1993
Commercial banks assets on GDP 1992–2004
Four-firm concentration ratio on assets 1997–2002
HHI Index 1997–2002
Efficiency index VRS 2001–2012
Efficiency index CRS 2001–2012
Efficiency index SCALE 2001–2012
Efficiency index for system, local and foreign banks
Efficiency index, foreign banks: M&A vs de novo
Efficiency index, foreign banks by nationality
Efficiency index, system and the seven largest banks
Boone competition index for seven countries of
Latin America, 2001–2011
Bank profitability, 2001–2013, average of the system

39

40
40
47
48
50
56
57
57
90
90
91
92
93
94
95
135
135

Tables
3.1
3.2
A.3.1
A.3.2
A.3.3
5.1
5.2
5.3

Process of bank privatization
Mergers and buy-outs (1994–2002)

Authorization to new commercial banks after the 1995 crisis
Authorizations to Sociedades Financieras Populares
Authorizations to new savings and credit cooperatives
Banks by nationality
Efficiency indexes by nationality, 2001–2012
Boone indicator

49
52
67
68
69
88
89
96


x

F I G U R E S A N D TA B L E S

5.4
5.5
5.6
5.7
5.8
A.5.1
A.5.2
A.5.3
A.5.4

A.5.5
A.5.6
A.5.7
A.5.8
A.5.9
6.1

6.2
6.3
A.6.1
A.6.2
A.6.3

Major changes to Mexico’s banking institutional framework
Variables summary
Tobit regression, efficiency coefficient as the dependent
variable (VRS)
Tobit regression, efficiency coefficient as the dependent
variable (CRS)
Tobit regression, efficiency coefficient as the dependent
variable (SCALE)
VRS efficiency index, 2008–2012
CRS efficiency index, 2008–2012
SCALE efficiency index, 2008–2012
Panel data—random effects, efficiency coefficient as
the dependent variable (VRS)
Panel data—random effects, efficiency coefficient as
the dependent variable (SCALE)
Panel data—random effects, efficiency coefficient as
the dependent variable (CRS)

Panel data—fixed effects, efficiency coefficient as
the dependent variable (VRS)
Panel data—fixed effects, efficiency coefficient as
the dependent variable (CRS)
Panel data—fixed effects, efficiency coefficient as
the dependent variable (SCALE)
Main powers granted to financial authorities in the 2007
Reform to the Law for Transparent and Ordered
Financial Services
Development banks, sector, and year of foundation
Ratio of development bank credit to commercial
bank credit by economic activity
Capitalization index of development banks, 2006–2013
ROA of development banks and commercial banks,
2011–2013
Delinquency index of the credit portfolio of
development banks and commercial banks, 2011–2013

99
100
101
103
105
109
110
111
112
114
116
118

120
122

131
136
139
156
157
158


PREFACE AND ACKNOWLEDGMENTS

C

ompetition in economic activities is relevant for any economy since
greater competition improves the efficient allocation of resources
enhancing social welfare. Mexico is a particularly representative case. The
lack of competition is visible in various sectors of the Mexican economy,
among them telecommunications, aircraft, media, food and agro-industrial
goods, and mining. In fact, some of the most dynamic sectors of the
Mexican economy are considered highly concentrated and show low levels of competition. There are consequently effects in the efficiency of
markets.
Since several years ago, competition in the banking industry has been
at the center of the public debate and has caught the attention of the
Mexican financial authorities. Likewise, competition in the financial sector
has drawn regulator’s attention in most of the world. This is not accidental.
The nature of the financial activities is prone to market failures: presence of
multiproduct firms, a production function with scale and scope economies,
high entry costs, firms that manage risk and information of economic

agents, high regulation and entry barriers, among others. It is not surprising that credit to GDP in Mexico shows very low levels compared to its
peer economies; net interest margins have remained high and financial
inclusion is low.
The financial sector is particularly special because of the well-known
functions that it performs in the economy, its unmistakable effect on economic growth and its fiduciary role in society. Hence, obstacles to competition that affect efficiency have ramifications in all the economy. In fact, the
expansion of financial services would further enhance growth since lack of
financing is one of the main constraints for firms in Mexico.
Our aim in writing this book is twofold. We are interested in answering the general question of the importance of competition and efficiency
in banking. And second, we are interested in having a precise evaluation
of competition and efficiency of banks in Mexico, and to document a
clear view of the status of competition in the financial industry of that


xii

P R E F A C E A N D A C K N OW L E D G M E N T S

country. Overall, our aim is to better understand how policies that have
been implemented during the last decade are framed to promote competition in the Mexican banking industry. It also helps to establish a correspondence between academic studies, policy assessments and current
policies. A recently enacted financial reform in Mexico aims to foster the
competitive conditions of the banking industry and this is discussed in
the book.
The writing of this book started in 2012 as a working paper written
by Jesús and Sara, “Competition and Efficiency in the Mexican Banking
Sector.” This paper was presented at the Latin American Meetings of the
Econometric Society (Mexico City, November 2013), where it grabbed
the attention of editorial staff of Palgrave Macmillan who contacted Sara
and proposed to her writing this book. As Sara and Jesús realized that their
research might spinoff to a broader work it became evident the need to
bring on board a third author, Gustavo, who has expertise in the evolution

and structure of the Mexican banking system.
Jesús has studied the relationship between market structure and efficiency
with bank performance and competition in the Latin American banking
industry since his doctoral dissertation. In addition, he has published several papers about market power, efficiency, productivity, and competition
in Latin American banking and more recently focusing on the Mexican
banking industry. Among his most recent studies regarding Mexican banking, Jesús has studied the influence of market power on bank profits, the
determinants and evolution of bank efficiency, and the relationship between
bank competition and financial stability.
Sara, who has worked as economist in the banking industry and in
the central bank, has several contributions to the banking literature that
explain the effect of regulations and policy in the activity of the Mexican
financial markets. As the chief economist of the Mexican antitrust authority, Sara headed the efforts to produce the document “Research and
Recommendations on Competition Conditions in the Financial Sector and
its Markets,” which that authority published in 2014, to fulfill that authority’s mandate according to the financial reform to assess the conditions of
competition in the financial markets and, formulate recommendations to
financial authorities to enhance competition in the system and its markets
as well as exercise its powers to sanction monopolistic practices and other
restrictions to the efficient functioning of the markets in this system.
Gustavo has published several books and papers about the history and
structural evolution of Mexican banks during the last century. The waves of
consolidation of financial intermediaries and the persistent concentration of
the banking system have been always present in his work, as well as the episodes when the industry has opened. This is essential to explaining some of


P R E F A C E A N D A C K N OW L E D G M E N T S

xiii

the sources of concentration in the Mexican banking industry, and to have a
long term view of the structural changes until the most recent events.

The writing of the book presented challenges. Although all of the
authors study the banking industry, the areas of expertise are different and
a clearer structure and framework of the contents was needed to enrich
the book. Comprehensive literature reviews on the analysis of competition
and efficiency in the banking industry generally and in Mexico’s banking
in particular were natural extensions of the seminal article. Also, because
of the ebb and flow observed in the consolidation of this system through
time and the importance attached to concentration as a potential source
of market power, we decided to provide the reader with the background
that allows a better understanding of Mexico’s banking industry development and challenges. Lastly, since an ambitious financial reform that modified 34 laws and codes took place in 2014, with an important emphasis
in competition issues, we decided that our book would not be complete
without offering the readers a general view of this reform and its possible
consequences.
Notwithstanding the technical work, the framing of aspects related to
policy always poses a challenge.The development of a policy to foster competition in the financial system, from the reduction of entry barriers to the
enactment of the 2014 financial reform, is still work in progress and thus it
is relatively early to assess some of its results, and consequently to have an
adequate analytical frame. Regarding the role of the regulators in competition, there is not a last word about the role of different regulators to assess,
prevent and enforce the law in anticompetitive practices; nevertheless the
authors agreed to take a stance in this matter. A further challenge was that
there is not a vast number of studies about competition in the Mexican
financial system, so there are not many points of reference in the literature
for every topic discussed in the book. However, there is a critical mass of
papers, books and policy reports published that preceded this book and
allow having a solid base for the analysis.
In its origin this book would not have been written without the encouragement and support of the heads of BBVA Research, Jorge Sicilia, Alicia
García-Herrero, and Carlos Serrano.Valuable comments to a draft of chapter 5
in its article form were provided by various participants at workshops at
BBVA Bancomer, Banco de México (Central Bank of Mexico) and the
Latin American Meetings of the Econometric Society of 2013. Gustavo’s

conversations with Guillermo Zamarripa, José Luis Negr ín, Enrique
Cárdenas, and Bernardo Bátiz-Lazo were helpful to frame the sections
about the structure of the Mexican banking system and the recent developments. Sara benefited from multiple conversations with Biliana Alexandrova,
Rafael Del Villar, Blanca Nelly Flores, Lorenza Martínez, Alberto Mendoza,


xiv

P R E F A C E A N D A C K N OW L E D G M E N T S

and Francisco Solís to understand payment systems and instruments for the
writing of those sections of the book. Valuable guidance throughout the
editorial process was provided by Leila Campoli and Sarah Lawrence, from
Palgrave Macmillan. We thank very much all of them.
The views expressed in this book represent those of the authors and do
not necessarily those of the institutions where they work at present or have
worked in the past.


CHAPTER 1
INTRODUCTION

T

he study of competition in the financial system has gained the increasing attention of policymakers and researchers. The structure of the
financial industry and the interaction among its players has changed substantially in the preceding years, particularly after the 2008 global economic
crisis. However, scholars have not been able to agree so far on, or resolve
how, to accurately analyze competition in the banking system and how
the state of competition relates to the efficiency and overall stability of the
banking system. All these questions are relevant for the implementation

of competition policy and to clarify key theoretical aspects of competition in the financial markets. In this book, our analysis of competition in
the Mexican financial system provides some answers to these important
questions.
The central finding of this book is that competition enhances the efficiency of the Mexican banking sector. We show that the level of competition of Mexican banks increased from 2002 to 2005, achieving its highest
level in 2008. It is important to mention that during the period 2006–2008,
16 commercial banks entered the market, which could explain the improvement in the competitive levels in that period. Afterward, and probably due
to the financial crisis, there was a decline in the competition levels, particularly in 2009, and a weak recovery thereafter.
We find that besides competition, other variables that increase Mexican
banks’ efficiency are the level of capitalization and loan intensity. Noninterest
rate expenses and nonperforming loans, on the other hand, decrease bank
efficiency, as also do higher inflation rates. The results suggest that overall
efficiency of Mexican banks increased during the last decade until 2008,
once the global financial crisis started, when efficiency declined noticeably
and has gradually improved since then. However, it has not recovered the
levels observed before the crisis. Regarding the relative efficiency of local
or foreign ownership of banks, we show that the system’s trend is a shared


2

COMPETITION AND EFFICIENCY

characteristic among both local and foreign banks. However, local banks are
more efficient. Banks that became foreign through a merger or acquisition
are more efficient than de novo banks, and the Spanish banks display higher
efficiency indexes than those of other nationalities.
This book also shows that designing a competition policy for the financial industry requires an in-depth analysis of the conditions of the market. This is because it needs to be effective and at the same time it may
increase the regulatory burden on financial institutions. Mexico’s banking
system constitutes an interesting case study for various reasons. Mexico is a
developing country with a well-regulated and sound banking system, and

an industry with a strong participation of global systemic banks. However,
it continues to be a financial system with low financial deepening in the
economy. This is the result of the changes experienced by the Mexican
financial system over the last 30 years, which have completely transformed
the architecture, the structure of ownership and control, as well as the competitive conditions of the financial system.
In spite of the growing literature about the Mexican banking sector, in
general, and competition conditions, in particular, the analysis of competition in the emerging financial markets is still scarce, although the literature
and financial press make a constant reference to the Mexican banking sector’s
competition conditions and well functioning. An ongoing argument about
the Mexican financial system is that the banking system experiences low
levels of competition, thus undermining its role as a catalyst in the potential growth of the economy (Haber 2005; Hanson 2010). This argument
is usually based on the high concentration ratios that have been persistent
throughout the history of the Mexican banking system. It is important to
note that a highly concentrated banking sector does not necessarily imply
low levels of competition. Thus, other elements such as profit margins and
prices must be taken into account when analyzing the competition conditions in the banking system.
We seek to contribute to the understanding of competition policy in
the banking system and to explain how levels of competition relate to the
efficiency of banks. The rest of the book is organized into five chapters that
provide summaries of the theoretical literature on competition, efficiency
and productivity in the banking sector, and the relevant applications of such
models for the Mexican banking system.
Chapter 2 explains the conceptual framework used in the analysis
throughout the book as well as a review of the main banking literature on
market power, efficiency, and competition. The chapter commences with
a discussion of the market power and efficiency hypotheses of industrial
organization, which posit contrasting views about the relationship between
market power and profitability.

I N T RO D U C T I O N

3

The traditional structure-conduct performance (SCP) hypothesis proposes that market power has a direct relationship with profitability, in which
firms can set less favorable prices to consumers in more concentrated markets as a result of anticompetitive behavior. In this framework, the characteristics of the structure of the market, such as the number and types of
firms in a market, entry barriers, market share and market concentration,
competition and regulatory policies, are relevant to determine the conduct
of the main market participants. A related theory is the so-called relativemarket power hypothesis (RMP), in which firms with large market shares
and well-differentiated products exert pricing advantages and earn profits
above competitive levels (Berger 1995). The first studies that investigated
these hypotheses found a positive relationship between concentration and
profits, conducive of collusion (see Gilbert 1984; Rhoades 1977, 1982,
among others).
The alternative efficient-structure (ES) hypothesis challenges this view
by arguing that higher concentration is often derived from greater market
share of more efficient firms. That is, higher levels of concentration are
often the result of greater market shares of firms that achieve lower costs
than others. Berger (1995) elaborated further and suggested that there are
two distinct ES hypotheses: (a) X-efficiency, in which firms with greater
management skills and better technologies have lower costs and therefore
higher profits; and (b) scale-efficiency, where firms produce at more efficient scales than others lowering their unit costs and boosting profits.
Hence, while the market power hypotheses postulate that market power
has a direct relationship with profitability, in which firms set less favorable
prices to consumers in more concentrated markets as a result of anticompetitive behavior, the efficiency hypothesis proposes that higher levels of
concentration are often the result of higher market shares of firms that are
more efficient than others.These hypotheses have been thoroughly debated
in the academic circles, and although empirical evidence testing the market
power and efficient-structure hypotheses has found similar results, there are
distinct interpretations. The different interpretations of the aforementioned

relationship as well as the empirical evidence are analyzed in this section.
While the majority of the original studies focused on the banking system of
the United States and found support for the market power hypothesis, other
studies have extended the time period of study, adding different geographical locations, and have found contrasting results.
As for the developments for measuring efficiency and competition in
the banking industry, we explain various approaches and methodologies to
measure both efficiency and competition. The assessment of efficiency has
evolved from standard accounting ratios to best-practice frontiers, in which
any deviations from the frontier are considered inefficiencies. Two distinct


4

COMPETITION AND EFFICIENCY

approaches to measure efficiency are addressed in this section: parametric
and nonparametric. Parametric methodologies, such as the stochastic frontier approach, are based on specific functional models for cost, profit or production relationships considering specific inputs, outputs, and other factors
that rely on a theoretical hypothesis. Nonparametric methodologies, such
as the data envelopment analysis (DEA), are based on a production or cost
frontier. Although these techniques rely on similar efficiency concepts, in
sharp contrast with the parametric methodologies, they generate the functions of interest, for example, the production function, from the observed
data instead of a specific functional form. In the analysis of the distance to
a best-practice frontier in order to measure efficiency, the concept of the
displacement of such frontier, from one period to another, hints at productivity changes. In theory, such displacement of the best-practice frontier
alongside the changes in the distance from banks to the frontier denotes
the level of productivity changes. We discuss the nonparametric Malmquist
index to measure productivity in this section.
Moreover, following the new industrial organization theory, nonstructural methodologies to measure competition are analyzed considering that
the traditional structural approach does not take into consideration the
revenue-cost structure of firms.

The empirical evidence of some of the approaches and methodologies used are also mentioned in this section. Although most of the original
applications on both the market power and efficiency hypotheses and on
bank efficiency focus on studying the US banking system up to date, there
is an increasing number of applications of these models for the banking sectors of other countries and regions.This has been possible as data constraints
have been relaxed as a result of new models or as more complete data sets
about banks have become available.
The last section of this chapter is dedicated to a more recent literature
that examines the relationship between competition among banks and the
stability of the financial system. There are two contrasting views. Some academics have argued that more competition enhances the stability of the
system, the so-called “competition-stability” view, while others suggest a
negative relationship between bank competition and financial stability, supporting the “competition-fragility” view. These views have initially been
tested in a few studies for the banking system of the United States and,
increasingly, for other countries, in both cases with mixed evidence.
Chapter 3 explains the evolution of the Mexican financial industry. The
goal of this chapter is to describe in detail the evolution of the Mexican
banking sector and how it underwent cycles of consolidation. This analysis
addresses the structure of the industry: players, market shares, main market
segments, and transformation in ownership. In contrast to other recent


I N T RO D U C T I O N

5

studies that focus in short periods of time, we elaborate in a more detailed,
long-term view. This is important because the Mexican banking sector
has experienced many changes during the last 30 years, and the most significant have taken place over the last 15 years. Particularly, in the last
30 years, the Mexican banking industry has changed from being a local
industry, protected and established by specialized intermediaries, to a stateowned industry after an expropriation in 1982, to finally become a private industry, and more recently an industry made up of financial groups,
many of them controlled by major international financial corporations.

This was not a smooth process; on the contrary, it was a complex development that generated high costs to the Mexican economy. Events such
as the nationalization in 1982 and the crisis in 1995 changed the direction of this evolution irreversibly and triggered unexpected consequences.
Despite the internationalization of the Mexican banking system being part
of an ongoing globalization process that has been of particular relevance
in Latin America, the expansion of international banking in Mexico actually was accelerated by the crisis and was made possible due to the North
American Free Trade Agreement (NAFTA). The last section of the chapter
is a description of the situation of the banking sector and the changes in
regulation—mostly to reduce entry barriers and stimulate credit growth—
before the financial reform of 2014. This chapter highlights the driving
forces for the consolidation of the banking system, and the process to
improve the conditions of competition.
Chapter 4 explains what is currently known about competition in the
Mexican banking industry. The goal of this chapter is to map the state of
knowledge, contrast the studies about Mexico with studies in other economies, and discuss the main limitations of the current studies. First, this is
important to dispel myths and platitudes about competition in the Mexican
banking sector. Second, it is also vital to assess the type of analysis needed
by authorities who implement competition policies and discern whether it
differs from other views.
As in other countries, the lack of detailed public data about the Mexican
financial system has limited the analysis of these topics. However, the availability of such data since the beginning of the twenty-first century has
allowed more quantitative research. Most studies that measure competition in Mexico’s banking sector rely on a combination of concentration
indexes and regulation/institutional analysis of market contestability or on
the estimation of the H-statistic proposed by Panzar and Rosse (1987),
which is characterized by demanding less data in its estimation than other
models like the one of Bresnahan (1982) and Lau (1982). Although most of
the studies document an imperfectly competitive market, with competition
problems in some segments like the credit card market, there are also some


6

COMPETITION AND EFFICIENCY

studies that have documented episodes of fierce competition or “supercompetitive” behavior among Mexican banks. In such a supercompetition,
banks run at levels of output where the marginal cost exceeds the marginal
revenue because they believe that by expanding their market shares, even
by incurring losses, they obtain a positive present value of expected future
returns. Another finding of these studies is that the degree of competition is not homogeneous across markets for different financial products.
Some markets that have experienced entry of nonbank intermediaries, like
mortgages, or competition from foreign institutions or capital markets, like
corporate credit, are found in empirical studies to be more competitive than
the credit cards or deposits markets where banks predominate.
Because of the empirical exercise that we undertake in the following
chapter, measurements of banking sector’s efficiency using nonparametric
techniques, such as DEA, are of special interest in the review of studies
about the Mexican banking system. In fact, these tools have been regularly
employed in Mexico, particularly in light of the 1995 Tequila crisis and the
liberalization that followed it.The view that emerges from this set of studies
is that although the sector’s efficiency has increased overall since then, efficiency differs among different groups or types of banks.
By contrast, in regards to the “competition-stability” and “competitionfragility” views, it is found from the scant studies that are available for Mexico
that they vary according to the period analyzed and whether the Mexican
banking system is examined alone or with a set of other countries.
Chapter 5 provides an estimation of efficiency indicators for Mexico’s
banking system for the period 2002–2012 using the DEA technique.
Besides presenting estimations for the aftermath of the 2008 financial crisis that allow to examine its effect on the system’s efficiency compared
with previous results, it tests through Tobit panel regressions the relevance
of several factors that affect efficiency, including bank characteristics, macroeconomic and regulatory conditions, and market structure. The most
salient innovation with respect to previous studies is the estimation of
the so-called Boone competition index (Boone, Griffith, and Harrison
2005) to assess competition and its inclusion as an explanatory variable

in the model of bank efficiency determinants. But also of interest in view
of the local debates on the merits of the predominant presence of foreign
banks in the system is the comparison of efficiency measures among the
different groups of banks. Our efficiency estimates allow us to look at this
issue in a very detailed manner.
Chapter 6, starts with a brief discussion on the role of the government
in promoting competition in the financial system and a description of the
regulatory framework and situation of the banking sector in place before
the financial reform of 2014. Then it describes the comprehensive financial


I N T RO D U C T I O N

7

reform that took place in Mexico in January 2014 as well as the key findings and recommendations of the study by Mexico’s antitrust authority
on the competitive conditions of the financial sector and its markets, with
an emphasis on those that pertain the banking system. This chapter portrays how competition policy in Mexico did not start from scratch, as the
financial reforms of 2014 were preceded by various law reforms intended
to improve consumer protection, as a means to improve the conditions in
which financial services were provided. However, competition policy was an
important ingredient of the financial reform reflected in both modifications
of various financial laws and as the mandate for undertaking a comprehensive study that allowed to both propose further reforms to the regulators
and to investigate anticompetitive practices. The chapter concludes with a
description of the effects of the reform so far and an assessment of whether
we can expect a more efficient and competitive banking system in the future
as a result of these reforms.


CHAPTER 2

LITERATURE REVIEW OF BANKING STUDIES

2.1 Introduction
Banks are important in mobilizing and allocating savings in an economy and
can solve important moral hazard and adverse selection problems by monitoring and screening borrowers and depositors. Besides, banks are important
in directing funds where they are most needed in an efficient manner and
have direct implications on capital allocation, industrial expansion, and economic growth (Berger, Demirguc-Kunt, and Haubrich 2003; Levine 1997).
Banks also play an important role in diminishing informational asymmetries
and risks in the financial system. Hence, the study of the banking industry
and its impact on the economy is of the utmost importance. The effects of
concentration and competition on bank performance are pertinent since
they have important policy implications. A recent global trend of consolidation in the banking sector has intensified, generating important debates on
its effects on the profitability of banks, consumer costs, the efficiency in allocating resources in an economy, and on overall financial stability.
In this chapter we present and overview of this literature, starting with
a brief survey of the industrial organization theories of the market power
and efficient-structure hypotheses that have been put forward to explain
the relationship between the structure of the banking sector and its performance in section 2.2. Then, section 2.3 is dedicated to discussing the
measurement of banks’ efficiency, which is key in the proper assessment
of the structure and profitability of the banking industry and, ultimately,
of competition conditions. Two main methodologies, parametric and nonparametric, are discussed and analyzed as well as various examples of the
empirical literature. Furthermore, banking productivity is presented following the efficiency discussion. The nonparametric Malmquist productivity
index is detailed followed by some empirical evidence in the literature. The
discussion of the studies about competition in banking follows in section
2.4; here again two broad categories are distinguished; structural models


10

COMPETITION AND EFFICIENCY

that follow the market power and efficient structure theories and nonstructural models in line with the new industrial organization theory. Some
of the latter models are discussed in this section. Section 2.5 covers some of
the most representative empirical studies of this vast and growing literature,
which spans various time periods and geographical areas. However, we defer
the discussion of the studies for the Mexican banking sector to chapter 4.
Section 2.6 deals with a more recent but growing literature strand on the
relationship between bank competition and financial stability; akin to the
market power and efficient structure models of the relationship between
banking structure and profits, two opposing views of the effect of competition among banks and stability of the banking system have been posed,
namely the “competition-stability” and “competition-fragility” views, giving place to growing academic discussions. Some conclusions are presented
in the final section 2.7.
2.2 Market Power versus Efficiency
Industrial organization studies have for long analyzed the concentration–
profitability relationship in banking to assess if the structural features of a
market influence the performance of banks in setting above-competitive
prices, such as higher loan rates and lower deposit rates. The traditional
structure-conduct-performance (SCP) hypothesis, first proposed by Bain
(1956), posits that market power has a direct relationship with profitability,
in which firms can set less favorable prices to consumers in more concentrated markets as a result of anti-competitive behavior (Berger and Hannan
1989). According to the SCP hypothesis, the characteristics of the structure
of the market are relevant to determine the conduct of the main market
participants. Therefore, the number and types of firms in a market, entry
barriers, market share and market concentration, and competition and regulatory policies become relevant to analyze the structure of the market.
According to the market power hypotheses a direct link between structure
and conduct (profitability and performance) can be established.The analysis
of bank performance has important social and economic impacts since the
efficient and optimal allocation of resources through intermediation can
produce welfare optimization (Dansby and Willig 1979).
A related theory is the so-called relative-market power hypothesis
(RMP), in which firms with large market shares and well-differentiated

products exert pricing advantages and earn profits above competitive
levels (Berger 1995). The first studies that investigated these hypotheses
found a positive relationship between concentration and profits, conducive of collusion (see Gilbert 1984; Rhoades 1977, 1982, among others).
These studies often employed simple measures of concentration such as


L I T E R AT U R E R E V I E W O F B A N K I N G S T U D I E S

11

the Herfindahl-Hirschman index (HHI)1 or an n-firm concentration ratio
as exogenous indicators of market power and most of them were limited
to analyzing the US banking markets, and used cross-section static panels
or short-run time periods.2
As said before, there could be a direct relationship between the structural features of the industry with bank performance, producing collusion
effects in the market. According to economic theory, the ability of a firm
i to increase prices above its marginal cost depends on the price-elasticity
(η) of the industry, the market share of each firm (MSi), and the production
variation of the reaming firms participating in the industry. Accordingly, the
following profit equation for firm i is (Rodríguez-Montemayor 2003):
π i = P (Q )qi − c i (qi )

(1)

where P is the price in the industry, qi and ci(qi) are the production and
the costs of firm i respectively, whereas Q is the total production of the
industry. Next, by differentiating equation 1 by q we obtain the first-order
conditions:3
π/δ qi

(dP//d )qi − CMgi = 0

(2)

where CMgi is the marginal cost and is defined as dci/dqi, while the sum of
the remaining terms represent the marginal revenue of firm i.Therefore, the
marginal revenue can be defined as:
P − (P/ )si

P ⎡⎣1 (dP/dQ )(Q/P )(qi /Q)
Q ⎤⎦

(3)

Substituting this equation in equation (2), we obtain the market equilibrium with marginal costs:
si

(P − CMggi )/P
P

(4)

If firms have the same marginal costs, then si = 1/n:
(

gi )//

/nη

(5)

Multiplying equation (5) by the market share and summing for n firms we
obtain an equation related to average margins (prices minus costs) for the
industry with the HHI:

(P

si −

CMg )/P = HHI /η
) ∑ s /η ⇒ (P − CMg

CMgi si P =

2
i

(6)