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OSAM MARK

PG/M.Sc/09/54338

IMPACT OF COMPETITION ON THE PROFITABILITY

OF COMMERCIAL BANKS IN NIGERIA

FACULTY OF BUSINESS ADMINISTRATION

BANKING & FINANCE

Chukwueloka.O.

Uzowulu

Digitally Signed by: Content manager’s

Name

DN : CN = Webmaster’s name

O= University of Nigeria, Nsukka

OU = Innovation Centre

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IMPACT OF COMPETITION ON THE PROFITABILITY OF

COMMERCIAL BANKS IN NIGERIA

BY

OSAM MARK

PG/M.Sc/09/54338

DEPARTMENT OF BANKING AND FINANCE

FACULTY OF BUSINESS ADMINISTRATION

UNIVERSITY OF NIGERIA, ENUGU CAMPUS

DECEMBER, 2015

3

IMPACT OF COMPETITION ON THE PROFITABILITY OF

COMMERCIAL BANKS IN NIGERIA

BY

OSAM MARK

PG/M.Sc/09/54338

BEING AN M.Sc DISSERTATION PRESENTED TO THE DEPARTMENT OF

BANKING AND FINANCE, FACULTY OF BUSINESS ADMINISTRATION

UNIVERSITY OF NIGERIA, ENUGU CAMPUS.

IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD

OF A MASTER OF SCIENCE (M.Sc) DEGREE IN BANKING AND

FINANCE.

SUPERVISOR: PROF. CHUKE NWUDE

DECEMBER, 2015

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CERTIFICATION/APPROVAL

This is to certify that this research work on the Impact of Competition on the

Profitability of Commercial Banks in Nigeria (2005 – 2013) carried out by OSAM,

MARK under supervision, has satisfied the necessary requirements for the award of

the Master of Science Degree (M.Sc) in Banking and Finance of the University of

Nigeria, Enugu Campus.

………………………..

……………………..

Professor E. C. Nwude

Date

(Supervisor)

………………………..

……………………..

Professor E. C. Nwude

Date

(Head of Department)

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DECLARATION

I, Mark Osam, a Postgraduate Student in the Department of Banking and Finance

with Registration No. PG/M.Sc/09/54338 do hereby declare that the work embodied

in this research thesis is original and has never been submitted either in part or in full

for any Diploma or Degree of this University or any other Institution of Higher

learning.

……………… ………………..

Mark OSAM Date

PG/M.Sc/09/54338

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DEDICATION

I dedicate this work to my wife, Mercy D. Osam, who agreed to marry me despite

her several other options and to all my friends in our Imanna-Yok Association,

Ohumuruktet, who may never have this privilege of completing an academic

research work.

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INSPIRATION

In completing this research work, I drew so much inspiration from the achievements

of my academic mentor, Dr. Eze A. Eze, who could effortlessly traversed academic

hurdles in Economics, Banking and the Legal Profession. Ofem Ofegobi

Balinwo,who as a boyhood mentor who has grown to show the world his ingenuity in

strategic thinking, leadership skills, academic brilliance and for never ceasing to

remind me of my academic potentials by constantly challenging me to forge ahead.

Aya Matthew Oguni serves as my village role model as he is the only youth that

never saw the four walls of a Secondary School but could effortlessly write and pass

the SSCE in 1990. To him being financially handicapped has never dimmed academic

brilliance.

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ACKNOWLEDGMENT

Acknowledgments are usually one of the most difficult sections to write in research

work such as this. The reason is because it is difficult to concisely mention all the

people who have assisted in one way or the other in the successful completion of the

work. It is even more difficult to stop mentioning people whose love, attention and

encouragement should be placed on record for recognition purposes. At the

preliminary stages of this work, I had to change my research supervisors from Prof. C.

U. Uche to Prof JUJ Onwumere when the earlier had to proceed on his sabbatical.

Combining the duties of an incumbent Head of Department, Banking and Finance

with the voluminous research materials of several graduating students could not allow

Prof Onwumere to conclude my research supervision. The incumbent Head of

Department, Banking and Finance, Prof. Chuke Nwude had magnanimously assumed

this responsibility and graciously completed this. For all the fatherly role, advice,

directives and supervision, I remain eternally grateful.

Combining a successful professional banking career with great academic pursuits has

never been a mean feat as it is clearly stressful to successfully combine both.

However, this stress was ameliorated by the attention I received from colleagues like

Charles Ubagwu, Daniel Ukwu, Martins Ezeamama, Eze A. Eze, Isreal Igiri, Saheed

Laifa, Chinazu Akonye, Asian Umobong and several others, too numerous to

mention. I owe them this note of gratitude.

Though far away in Ohumuruktet village, my friends have always been a source of

great joy and motivation to me, always interested in my academic exploits even

though majority of them may never have the opportunity to complete an academic

research work. I specifically remember Ejukwah Amah, Ojen Ebey, Isua Ayang,

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Ayang Sunday, Gabriel Sunday, Sunday Oji, Okon Matthew and William Agbor;

these are people with natural intelligence but whose zeal for academic heights may

never be fully achieved because of our traditional poverty.

My family members took turns to bear the burden of my frequent absence from home

while in search of this Golden Fleece. The roles played by my daughters, Nsiyan

Osam and Macha Osam, who will constantly ask me if am leaving home again, are

greatly recognized here. My Son and Heir apparent, Phinsi Osam, who I hope to hand

over this baton, in further pursuits of academic heights is majorly noted too. My other

siblings and family members are not missed out here: Rose Kirian, Catherine Okimba,

Koko Dickson, Ndondo Asoha, Hillary Ogbu and my life protégée, Okimba Adomi

Ayang – Bee Jay and many others too numerous to mention. To them, I will always

remain a role model.

Dr. Okorn Osam remains my symbol,both of political leadership and family head.

This is a man who assumed headship ofthe entire family at a very tender age, may be

when he too needed guidance and has steered the ship of statesmanship so admirably

since early 1977. He has been my adviser, guardian and leader. I cannot thank and

appreciate him enough.

Whatever I am today, I owe all the gratitude and appreciation to just one woman, my

mother, apart from God almighty whose glory is for evermore. Many other people call

their mothers by pet names such as mummy, but, I still call and address mine as

Mama. A very rare and special gem who sacrificed so much, threaded our traditional

path of poverty and penury for so long, just in an effort to make me a better person in

our society, Ma Lucy P. Osam, I will always be your son. I sincerely lack the

appropriate words to convey my hearty appreciations to her but, if it pleases God to

spare my life further, I promise to repay her this debt, one day.

In spite of all the contributions, assistance and encouragement that I have received in

the course of this work (both the sources I referenced, acknowledged and others too

numerous to mention) I bear alone the full responsibility for the contents of this

research work and will remain answerable even to posterity for all the errors,

omissions and mistakes inherent in this work.

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LIST OF TABLES, GRAPHS AND CHARTS

Table 2.1 Interpretation of the PR H Statistic for Market Structures 33

Table 2.2 H Statistic for the Intensity of Competitiveness of some

African Countries 34

Table 2.3 Estimates for Efficiency Rating using the Profit

Maximization Model in some EU Countries 38

Table 2.4 Concentration Index for some African Countries using the

K Concentration Index 43

Table 2.5 Interpretation of Market Equilibrium position using the

Bresnahan Model 48

Table 2.6 H Statistic for some African Countries using the PR Model 61

Table 4.1 Summary of Aggregate Values of Variables 100

Table 4.2 Summary of Average Values of Variables 101

Table 4.3 E View Results used for Descriptive Analysis 102

Table 4.4 Summary: Average Values of PBT and Market Share 104

Figure 4.1 Chart of Profitability and Market Share of Commercial Banks

in Nigeria 105

Figure 4.2 Graph of Profitability and Market Share of Commercial Banks

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in Nigeria 106

Table 4.5 Summary: Average Values of PBT and Efficiency 106

Figure 4.3 Graph of Profitability and Efficiency Ratios of Commercial Banks

in Nigeria 108

Figure 4.4 Graph of Profitability and Efficiency of Commercial Banks

in Nigeria 108

Table 4.5 Summary: Average Values of PBT and Concentration 109

Figure 4.5 Chart of Profitability and Concentration levels of Commercial Banks

in Nigeria 111

Figure 4.6 Graph of Profitability and Concentration of Commercial Banks

in Nigeria 111

Table 4.7 Correlation- Results 112

Table 4.8 Results of Pooled OLS Regression Analysis 113

ABSTRACT

That the Banking Industry in Nigeria has always been profitable has never been in

doubt. Again, that the Nigeria banking industry has been a very competitive one is

also not a matter for contention as the result of several researchers measuring the

competition in the banking industry have sufficient empirical evidence to substantiate

this theory, however, what has recently become a contentious issue is to determine

what really drives banking profitability in the face of this cut-throat competition in

Nigeria. Not even the banking consolidation reforms introduced in Nigeria by the

erstwhile Governor of the Central Bank of Nigeria, Professor Charles C. Soludo, in

2005 which highlighted the unprecedented competition in the Nigerian banking

industrycan be agreed to the major determinate of banking profitability in Nigeria.

Generally, the impact of competition on the profitability of commercial banks in

Nigeria has been a subject of great scholarly inquiry and continues to occupy a large

body of empirical research. Competition in the banking industry is necessary as it

promotes economic growth by increasing firms’ access to external financing,

lowering the costs of providing banking products and services, managing and

mitigating banking risks, mobilizing savings and investment opportunities and

adopting efficiency strategies for improving profitability. Petersen and Ranjan (1995)

12

show theoretically that Commercial banks that wield substantial market share are

more profitable in developed economies as they can lend even to young firms whose

credit records may be opaque, hence leading to high loan volumes and substantial

increase in both economic activities and economic growth. However, Cetorelli and

Gamberra (2001) argue that, there is compelling evidence to suggest that the

profitability of commercial banks in most developing economies (for which Nigeria is

one) is a direct function of its banking efficiency and other ancillary variables and has

no direct relationship with the market share of firms.Hence, the profitability of

commercial banks in Nigeria can only be placed at the center of any developmental

economic agenda, if it combines optimally the determinates of banking profitability

such as market share, efficiency and concentration of commercial bank branches to

respond to the dynamic changes in economic conditions, especially, those that affect

delivery of financial services. Our major objective in this research is therefore, to

resolve the dilemma between the conflicting theories highlighted in the Structure

Conduct Performance Hypothesis - SCP (which propagates the ideals of significant

market share) and the theories of Efficiency Structure Hypothesis -ESH, (which gives

credence to the significance of banking efficiency) in assessing the impact of

competition on profitability of commercial banks in a developing country like

Nigeria.

TABLE OF CONTENTS

Title Page i

Certification/Approval ii

Declaration iii

Dedication iv

Inspiration v

Acknowledgment vi

List of Tables, Graphs and Charts vii

Abstract ix

Table of Contents x

Chapter 1 Introduction

1.1 Background of the Study 1

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1.2 Statement of the Problem 7

1.3 Objectives of the Study 9

1.4 Research Questions 9

1.5 Research Hypotheses 9

1.6 Scope of the Study 10

1.7 Significance of the Study 12

1.8 Limitations of the Study 15

References 16

Chapter 2 Review of Related Literature

2.1 Introduction 23

2.2 Theoretical Review of Related Literature 25

2.2.1 Market ShareModels 30

2.2.2 Efficiency Models 34

2.2.3 Bank Concentration Models 38

2.2.4 Drivers of Competition in the Banking Industry 42

2.2.5 Competition that Causes Economic Crises 52

2.3 Empirical Review 59

2.4 Review Summary 63

References 66

Chapter 3 Research Methodology

3.1 Research Design 76

3.2 Nature and Sources of Data 77

3.3 Population and Sample Size 77

3.4 Model Specification 78

3.5 Description of Research Variables 80

3.5.1 Dependent Variables 81

3.5.2 Independent Variables 83

3.5.3 Intervening Variables 86

3.6 Techniques for Data Analysis 89

References 91

Chapter 4 Presentation and Analysis of Data

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4.1 Introduction 96

4.2 Presentation of Data 97

4.2.1 Descriptive Statistics 98

4.3 Results of Correlation Analysis 108

4.4 Results of Regression Analysis 113

4.5 Test of Hypotheses 114

4.5.1 Test of Hypothesis 1 115

4.5.2 Test of Hypothesis 2 116

4.5.3 Test of Hypothesis 3 117

References 119

Chapter 5 Summary of Findings, Conclusion and Recommendations

5.1 Introduction 123

5.2 Summary of Findings 123

5.3 Conclusion 124

5.4 Contribution to Knowledge 125

5.5 Recommendations 126

5.6 Recommended Areas for further Research 128

References 129

Appendices

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Competition in the banking industry has been a subject of great scholarly inquiry and

continues to occupy a large body of empirical research. That the Banking Industry in

Nigeria has always been profitable since the early 1990s has never been in doubt.

That the Nigeria banking industry has been a very competitive one is also not a matter

for contention as the results of several researchers measuring the competition in the

banking industry have sufficient empirical evidence to substantiate this theory,

however, what has recently become a contentious issue is to determine what really

15

drives banking profitability in the face of this cut-throat competition. Not even the

banking reforms introduced in 2005 which triggered unprecedented competition in the

banking industry in Nigeria can be agreed to the major determinate of banking

profitability in Nigeria. The reforms generally entailed the upward review of the

minimum capital requirement of banks from N2billion to N25billion (an increase of

approximately, 1,150%), a decrease in the number of commercial banks operating in

Nigeria from 120 in 1993 to about 24 commercial banks post consolidation in 2010

and a dilution in the ownership structure of most commercial banks as they

subsequently became publicly quoted companies on the Nigerian Stock Exchange

(NSE).

Generally, the impact of competition on the profitability of commercial banks in

Nigeria has been a subject of great scholarly inquiry. Banking competition promotes

economic growth by increasing firms’ access to external financing, lowering the costs

of providing banking products and services, managing and mitigating banking risks,

mobilizing savings and investment opportunities and adopting efficiency strategies for

improving profitability. Petersen and Ranjan (1995) show theoretically that

Commercial banks that wield substantial market share are more profitable in

developing economies as they can lend even to young firms whose credit records may

be opaque, hence leading to high loan volumes and substantial increase in both

economic activities and economic growth.

However, Cetorelli and Gamberra (2001) argue that, there is compelling evidence to

suggest that the profitability of commercial banks is a function of its banking

efficiency and other ancillary variables and has no direct relationship with its market

share. Hence, the profitability of commercial banks can only be placed at the center of

any developmental economic agenda if it combines optimally the determinates of

banking profitability such as market share, efficiency and concentration of

branches of the commercial bank to respond to the dynamic changes in economic

conditions, especially those that affect delivery of financial services. Our major

objective in this research is therefore, to resolve the dilemma between the conflicting

theories discussed in the Structure Conduct Performance Hypothesis - SCP (which

propagates the ideals of significant market share) and the theories of Efficiency

Structure Hypothesis - ESH, (which gives credence to the significance of banking

16

efficiency) in assessing the impact of competition on profitability in a developing

country like Nigeria.

From public policy perspective, competitiveness of the banking sector is agreed to

represent a socially optimal target, since it reduces the cost of financial intermediation

and improves delivery of high quality services thereby enhancing social welfare.

Banking competition also promotes economic growth by increasing firms’ access to

external financing (Beck, Demirgüç-Kunt and Maksimovic, 2004; Pagano, 1993).

However, Petersen and Ranjan (1995) show theoretically that banks wielding

substantial market share tend to lend to young firms whose credit records may even be

opaque, hence leading to high loan volumes.

In practice, Cetorelli and Gamberra (2001) argue that, although, concentrated banking

systems offer growth opportunities for young firms, there is strong evidence of a

general depressing effect on growth associated with banks’ exercise of market share

and this impacts all sectors and firms in the economy. Hence, competition in banking

should be placed at the center of any public policy agenda since it has the mechanism

to respond to the dynamic changes in economic conditions, especially those that affect

delivery of financial services. Relevant literature on the measurement of competition

in the banking industry may be divided into two broad mainstreams, the structural

approach and the non-structural approach (Mugume, 2010). The structural approach

to modeling competition is majorly made up of the structure-conduct-performance

(SCP) paradigm and the efficiency structure hypothesis (ESH) as well as a number of

other formal approaches which all have their roots in industrial organization theories.

However, sufficient theoretical and empirical evidence abounds that confirm that both

the SCP, ESH and the other market concentration indexes such as the Herfindahl-

Hischman index alone cannot be used to measure industry wide banking competition

because they have deficiencies that inhibit their effective use as a measure of banking

competition. Mugume (2010) stated some of these deficiencies to include a country’s:

Macro-economic performance

Financial stability

Form and degree of taxation of financial intermediation products

Quality of information and judicial systems

Scale of banking operations

Risk preferences

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The author opines that because of the highlighted deficiencies of the Herfindahl-

Hischman index, the use of these concentration measures present a poor indicator for

the degree of competition in the banking industry especially, for developing countries,

such as Nigeria (Mugume, 2010). However, concentration ratios as measures of

competition do not also provide adequate and conclusive explanations of actual bank

profitability and may lead to wrong inferences on competitive conditions (Hausman

and Sidak, 2007). Instead, Baumol (1982) opines that banking competition should be

assessed based on banking market contestability arising from the presence or absence

of entry barriers into the industry. Mwenda and Mutoti (2011) remedied this bias by

measuring banking competition in the Zambian banking sector using the H statistic

model developed by Panzar and Rosse (Simpasa, 2013). Although, there was a

significant improvement over the results of Baumol (1982) using banking

concentration ratios to measure the impact of competition, the authors did not

condition the competitive index on changes in market conditions brought about by the

entry of new foreign banks in the recent years and the privatization of the Zambian

National Commercial Bank (ZNCB) that took place in 2007 (Simpasa, 2013).

Profitability of Nigerian commercial banks has generally been buoyant, driven by

earnings on bank loans, commission n turnover, income from trading treasury

securities, realized gains on foreign exchange transactions and fee income which have

all contributed significantly to these commercial banks’ profits. Banks’ return on assets

(ROA) and the net interest margin (NIM) are the major proxies used to gauge banking

profitability and the intensity of competitive pressures on these commercial banks.

Depending on the market share of a bank in input and output markets respectively, it

may be able to increase output prices (lending rates) or decrease input prices (deposit

rates) with a view to increasing its profitability. Bank management can select the

combination of inputs (time deposits, fixed deposits, savings account deposits) and

outputs (loans) at which profits can be maximized (DeBandt and Davis, 2000).

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In order to avoid stating the obvious and to clarify our motives further, we start by

asking why a bank would not be able to maximize her profits. Let us consider four

issues related to profit maximization: (Berger, 1995).

(a) The role of diversification and risk preferences of the bank;

(b) The problems between shareholders and bank management;

(c) Imperfect competition and;

(d) Inefficient use of inputs and outputs.

A first consideration relating to bank profit maximization concerns the concept of risk

and its diversification. Shareholders will usually prefer to balance their appetite for

maximizing expected profits and minimizing costs with the amount of risk they are

willing to take. Abstracting from speculative motives, shareholders are generally

assumed to be indifferent to the distribution of profits, receiving a return on their

investment in the bank either through an increase in the bank’s share price or through

dividends received. If all the banks operating in the economy share the same risk-

return preferences, or if the risk-return relationship can be described by some

relatively simple homothetic continuous function, then there is no serious problem

with the fact that we may have to control for a bank’s risk preferences. Recent works

by DeYoung (1998) have tried to incorporate risk into a bank benchmarking exercise.

Given that this type of work is still in its infancy in developing countries, such as

Nigeria, we refrained from including risk and risk preferences in this research work.

Instead, we adopted other control variables such as bank regulation and bank

reputation that aim to proxy for banks’ risk-return preferences.

A second consideration relating to banks’ profit maximization, concerns incentive

structures. Even risk-neutral shareholders who are well-diversified may have

problems translating their claims on bank profits into actions required to maximize

revenue and minimize costs. In the absence of complete information, principal-agent

theory states that shareholders are unable to adequately monitor bank management

and that the resulting managerial discretion may induce sub-optimal behavior, i.e.

profits are not maximized and/or costs are not minimized (Berger and Humphrey,

1997). As long as shareholders cannot monitor and penalize bank management, the

latter may show expense-preference behavior or if the bank management is highly

risk-averse, it can adopt any other strategy that tends to reduce the profitability of the

19

bank (Hannan and Mavinga, 1980). This means that the asymmetric information

between principal and agent that was once used by Diamond (1984) to explain the

profitability of banks from a reduction in audit costs for lenders to non-financial can

also be used to explain why banks themselves may also suffer from moral hazards and

other compensation incentive problems in their profitability drive (Diamond, 1984).

Firstly, very few studies have attempted to test empirically the impact of principal-

agent conflicts on the performance of banks even in developed countries and

specifically in European banks. (Molyneux and Forbes, 1995) Translations into

empirical tests of the principal-agent conflicts described above where hidden actions

by or hidden knowledge of bank management which resulted in suboptimal

profitability measures. Secondly, to the extent that the principal-agent relationship

results in moral hazard conflicts, this will only create problems if the principal (i.e.

the shareholders) cannot insure himself against excessive risk-taking by the agent i.e.

the bank management (Meyer and Mugume, 2004). A vast amount of literature exists

on ways to minimize the negative effects of these principal-agent problems but have

not been considered in this research work.

Thirdly, price and non-price competition, the substitutability of bank’s products and

the contestability of banking markets may also serve to ensure that a bank’s optimal

profitability is not achieved by putting competitive pressure on its management,

provided that the bank’s management compensation is not performance-based

(DeBandt and Davis, 2000).

Whether compensation incentive problems are as important in determining why banks

themselves may also suffer from moral hazards as in developed banking economies as

there are in developing economies is still questionable (Molyneux and Forbes, 1995).

Although, these identified compensation incentive problems may lead to suboptimal

performances by banks, which is an anomaly to the cardinal objective in being in

business, the extent to which these incentives problems affect a developing country

such as the Nigeria banking industry is unclear. There are quite a few reasons to

suspect that the incentive problems that can cause a bank to make lesser profits or

experience above-minimum average costs are significantly different from bank to

bank, or from country to country. This is because the thin line of separation between

ownership and control is highly similar for commercial banks across developed

countries, especially in Europe (Goldberg and Rai, 1996). Therefore, even if

20

compensation incentives constraints can help explain bank performance, empirical

testing of these incentives to determine whether they can explain differences in bank

performance is difficult to achieve and their empirical results to date, have so far been

in conclusive. Also, commercial banks’ profitability is usually related to changes in

the environment and the behavior of their competitors (Molyneux, Lloyd-Williams

and Thorton, 1994; Goldberg and Rai, 1996; Levine, Laoyza and Beck, 2000).

Therefore, another consideration relating to banks’ profit maximization relates to the

market share of the individual commercial bank (Berger and Hannan, 1998).

Economic theory also tells us that in a perfectly competitive situation, profit

maximization is equivalent to cost minimization. In practice however, we do not

necessarily observe maximization of profits and/or minimization of costs. Of course,

exogenous factors such as regulation or (economic) shocks can cause suboptimal

performances for commercial banks. To the extent that these exogenous factors do not

have similar effects on both cost minimization and profit maximization, they can

drive a wedge between the two (Hannan and Mavinga, 1980). Imperfect market

structures can cause a situation where commercial banks’ profits are maximized at an

output level where average costs are no longer minimized, thus leading to achieving

sup-optimal profitability peaks by commercial banks (Vivex, 2001). This sub-optimal

profitability achievement can thus be used to explain changes in profitability levels

over time for firms as well as for commercial banks.

A bank may also produce at lower costs and with a higher profit than other banks if it

makes better use of its input resources and transforms them into outputs in the

cheapest possible way. In the long run, every bank has to produce efficiently in order

to survive banking competition. This brings us to the next factor driving

maximization of banking profits in Nigeria, which is banking efficiency.

The competitive indices for efficiency offer a practical perspective on the

understanding of banking competition in Nigeria and its policy implications. The

broad conclusion from several research analyses is that over a longer period of time,

commercial banks efficiency will begin to decline, underpinning the growing intensity

of competition, particularly in post financial reform periods (Mugume, 2010). This

suggests that the degree of competition may be higher for commercial banks before

banking reforms are introduced than after banking reforms are introduced in their

21

economies. Also, that the degree of competition from other forms of financial

intermediaries (capital markets, non-bank financial institutions, insurance companies)

play a role in determining the degree of competition in banking system. It has also

been shown, theoretically as well as empirically, that the degree of competition in the

financial sector can matter in assessing economic development.

1.2 Statement of the Problem

In the face of slowing industry growth and so much competition, today’s commercial

banks are under tremendous pressure to grow organically by gaining a proportionate

portion of the market share. A financial system’s contribution to the economy

depends on the quantity and quality of its services and the efficiency with which it

provides them (Mugume, 2010). According to Mugume (2010), there are two

plausible theories to determining the market share of competing banks towards

measuring their profitability and it is crucial to determine which of these two theories

more accurately describes their behavior with increasing profits, since the economic

policy implications derivable from either of these theories are radically diverse. The

first theory postulates that an increase in banks’ profitability is directly related to the

total efficiency improvement in its operations, termed the Efficiency Structure

Hypothesis (ESH) theory.

The efficiency hypothesis further expatiates that an increase in the total revenue of

banks’ as a result of improved efficiency will certainly increase that banks’

profitability. The other theory, the Structure Conduct Performance (SCP) Hypothesis

explains that an increase in the profitability of commercial banks is caused by an

increase in the market share and that being in possession of a considerable share of

the market, otherwise classified as possessing market power is attributable to the SCP

Hypothesis (Smirlock, Gilligan and Marshall, 1984; Mugume, 2010).

Relevant literature also suggests that there exists a relationship between concentration

and efficiency and between market share and profitability, as already highlighted

above. These relationships have generated competing hypotheses. On the one hand,

the traditional collusion theorists, also called the structure-conduct-performance - SCP

hypothesis (Bain, 1951) postulates that banking concentration lowers the cost of

22

collusion between firms and results in higher normal profits. On the other hand, the

efficiency theorists, proponents of the efficiency structure hypothesis - ESH

(Demsetz, 1973) postulated an alternative explanation for the existence of a positive

correlation existing between banking efficiency and profitability, affirming that only

the most efficient firms in any industry can attain greater profitability and

consequently their market shares can become more concentrated enhancing their

profitability. He, (Demsetz, 1973) concludes that, in such circumstances, the observed

positive relationship existing between concentration and profitability is spurious as it

simply proxies competition for an already existing positive relationships between

superior efficiency, market share and concentration. (Gibson and Tsakalotos,

1994).

This is the main problem that this research work helps to resolve - the dilemma

between the conflicting theories of structure-conduct performance hypothesis (SCP)

and the efficiency structure hypothesis (ESH) as to which of these theories really

drives profitability in Nigerian commercial banks. Is it the acquisition of a significant

market share or the adoption of an efficient banking approach that explains the

profitability of Nigerian commercial banks and other developing economies?

1.3 Objectives of the Study

The overall objective of this study is to empirically investigate the impact of

competition on the profitability of commercial banks in Nigeria. To achieve this

objective, the study strives to accomplish the following specific objectives:

1. Investigate the impact of market share on the profitability of commercial banks

in Nigeria.

2. Find out the impact of banking efficiency on the profitability of commercial banks

in Nigeria.

3. Investigate the impact of concentration on the profitability of commercial banks

in Nigeria

23

1.4 Research Questions

This study strives to provide answers to the following research questions:

1. What is the impact of market share on the profitability of commercial banks in

Nigeria?

2. What is the impact of banking efficiency on the profitability of commercial banks

in Nigeria?

3. What is the impact of banking concentration on the profitability of commercial

banks in Nigeria?

1.5 Research Hypotheses

In order to achieve the above stated research objectives and also answer the research

questions formulated above, the following research hypotheses have been tested:

1. Market share does not have a significant and positive impact on the profitability of

commercial banks in Nigeria.

2. Banking efficiency does not have a significant and positive impact on the

profitability of commercial banks in Nigeria

3. Banking concentration does not have a significant and positive impact on the

profitability of commercial banks in Nigeria.

1.6 Scope of the Study

This study covers the period 2005 – 2013 and gathers data from about 13 out of the 24

existing commercial banks in the country. 2005 is chosen as the commencement year

for the scope of this study because it was the first year in which financial statements

of commercial banks were prepared after the banking consolidation reforms which

were embarked upon by the erstwhile Governor of the Central Bank of Nigeria -

CBN, Professor Charles Soludo in 2004. The consolidation reforms generally entailed

the upward review of the minimum capital requirement of banks from N2billion to

N25billion (an increase of approximately, 1,150%), a decrease in the number of

commercial banks operating in Nigeria from 89 to 24 (post consolidation) and a

24

dilution in the ownership structure of most of these banks as most commercial banks

subsequently became publicly quoted companies on the Nigerian Stock Exchange.

(Nannyanjo, 2012). The financial year ending December 31, 2013 fits our terminal

date for the scope of this study because the data used in our analysis has already been

published by as of April 31, 2014. The 2004 financial reforms were also expected to

see to the emergence of a fewer number of commercial banks in Nigeria but with a

significant capital base. Mergers, acquisitions and other forms of business

combinations produced the resultant 24 commercial banks which triggered

unprecedented competition among the banks and the ultimate emergence of the five

big banks in Nigeria due to their huge capital base.

These banks are: First Bank of Nigeria – (FBN), Guaranty Trust Bank – (GTB),

Zenith International Bank – (ZIB), United Bank of Africa – (UBA) and Access Bank -

Access. Apart from these 5 big banks the other high efficiency emerging banks that

will be sampled in this study are: Ecobank International – (ECOBANK), Skye Bank –

(SKYE), First City Monument Bank – (FCMB), Union Bank of Nigeria – (UBN),

Diamond Bank – (DIAMOND), Fidelity Bank – (FIDELITY), Stanbic IBTC Bank –

(STANBIC) and Sterling Bank – (STERLING). These 13 banks are chosen out of

the 24 banks in the industry because in a recent study carried out by the Research

Department of FBN in 2013 comparing the market shares of commercial banks in

Nigeria for the financial year ending December 31, 2012 their combined value was:

(Appendix 1)

Total Assets (TA) 86% of Industry value

Total Deposits (TD) 86% of Industry value

Net Revenue from Funds (NRFF) 91% of Industry value

Operational Expenses (OPEX) 87% of Industry value

Profit before Tax (PBT) 94% of Industry value

From the analysis above, it is obvious that the other 11 commercial banks that do not

constitute a part of our sample merely control a minority value of the industry market

share as highlighted below:

25

Total Assets (TA) 14% of Industry value

Total Deposits (TD) 14% of Industry value

Net Revenue from Funds (NRFF) 9% of Industry value

Operational Expenses (OPEX) 13% of Industry value

Profit before Tax (PBT) 6% of Industry value

Broadly speaking, our knowledge about bank behavior, bank pricing of their products

and services in Nigeria is still very limited. There is a gap in empirical work on

whether competition in the banking industry has really increased in this era of

financial reforms in Nigeria (post banking consolidation reforms of 2004) or not.

Although, there are good reasons to believe that changes in banking regulations may

also affect the relationship between competition and profitability, it is not within the

scope of this research work to consider the influence of banking regulations on the

profitability of commercial banks in Nigeria.

1.7 Significance of the Study

While there has been a rapidly growing literature on banking profitability issues in

developed countries, little attention has been paid to the profitability of commercial

banks in developing countries, yet there is an increasing recognition that financial

sector development is a top priority for sustained economic growth in developing

countries like Nigeria. This research work aims to contribute to the existing literature

by analyzing the impact of competition on the profitability of commercial banks in

Nigeria during the recent post consolidation era of 2004 generally and specifically to

the following researchers and stakeholders:

26

a. Financial System Operators: The financial system of any economy is made of

its financial markets (commercial banks) and other financial institutions (discount

houses, insurance companies, bureau de change, stock broking firms, etc.) which

are central to its economic development and growth. Obviously, the financial

system tends to evolve around a strong banking system which can facilitate a

more efficient allocation of financial resources. The importance of a strong and

competitive banking sector in a country’s economic growth and development is

already well established in several banking competition literature (Beck, Levine

and Loayza, 2000). The efficiency theory highlighted in this research work if

adopted and implemented by the financial system operators will help to grow the

economy partly by widening access to external financing and channeling financial

resources to the economic sectors that need them most. (Mugume, 2010). A well-

developed financial system which results from a healthy competition in the

banking industry can also help an economy cope better with exogenous shocks

such as terms of trade volatility and move such nations away from natural

resource-based development to other competitive and viable economic growth

alternatives.

b. Bank Operators: It is necessary for every banking system to be competitive; this

is to ensure that banks are effective forces for financial intermediation, channeling

savings into investments that foster higher economic growth and other ancillary

functions of a commercial bank in an economy. However, it is also necessary to

monitor and control the impact of market share on the competitiveness of

commercial banks which is a major independent variable in measuring the impact

of competition on the profitability of commercial banks in Nigeria.

Bank Operators will therefore be more properly guided in adopting appropriate

strategies towards increasing their share of the market with a view to increasing

their profitability if they imbibe the recommendations in this research work.

c. Bank Regulators: A high degree of competition and efficiency in the banking

system can contribute to greater financial stability, product innovation and access

by households and firms to financial services which can in turn improve the

prospects for economic growth. In this respect, there is a real concern that a

monopolistic or oligopolistic, inefficient and fragile banking sector in Nigeria is a

major hindrance to economic development. Identifying the kind of reforms and

environments that may help to promote competition and efficiency in Nigeria’s

27

banking system is therefore very important to the regulators of the industry as

highlighted in this research work. In the light of most recent regulatory changes

affecting the United States of America (USA) financial industry, the policy

relevance for USA regulators is more current than ever. Such regulatory changes

continue to have a significant impact on the market share of the banking industry

and on bank’s competitive conduct. A deeper analysis of the economic role of

bank competition which has been highlighted in this research work should thus

contribute to our understanding of the responsibilities of bank regulators and the

consequences of excessive regulatory actions and therefore, support more

effective banking regulation. (Vittas, 1992)

d. Policy Makers: Financial markets and institutions are central to economic

development and growth. Increasingly, scholars acknowledge that a supportive

policy for financial sector development is a key component of national

development policy. The responsibilities of these policy makers can be positively

enhanced if they understand what really drives competition in the banking

industry especially for developing countries like Nigeria, which this research work

aims to espouse. A comparative analysis of the growth rates of different countries

has produced convincing evidence that having a deeper financial system

contributes to economic growth and that knowledge is not merely reflected in the

wealth and prosperity of a nation (Honohan and Beck, 2007). Moreover, the

development of the financial sector which can be driven by the competitive nature

of the commercial banking industry is fundamental to the conduct of monetary

policy. Countries with deep financial systems also seem to have a lower incidence

of poverty than others with the same level of national income.

A detailed analysis of the economic role of bank competition which has been

highlighted in this research work should also contribute to our understanding of

the responsibilities of policy makers and the consequences of recommending

stringent policies actions and therefore, support more effective policy making

(Vittas, 1992). Policymakers will typically recommend measures aimed at fueling

competition, promoting the liberalization of financial markets and removing

barriers to entry (Vittas, 1992) as recommended in this research work.

e. Bank Customers: For starters, bank customers can now hold their own against

the might of the banking industry. The democratization of information and

communication has turned the average banking customer into an aware and

28

confident individual who is not shy of voicing an opinion in public, this is one of

the positives of commercial banks adopting competitive measures. This evolution

has brought about greater diversity in consumer need, along with the expectation

of fulfillment since banks profitability has been matched to total customer

deposits and returned a positive correlation as highlighted in this research

work. Hence, every customer demands that his bank pay close attention to his

unique requirements and customize its products, services and experience to his

liking. Under severe competitive threat, the banks have no choice but to comply,

else it risks losing business to a rival that will.

Fortunately, the emergence of online technology, self-service mechanisms and

social media has made it feasible for banks to gather customer information in

granular detail and use that insight to restructure a defined basket of offerings into

an almost unlimited set of personalized variants. It goes without saying that a

flexible, agile and integrated core banking platform is absolutely necessary for

realizing this goal. This is why bank customers should know the impact of

competition on the profitability of their banks and hence their behaviors. Also,

since customer expectations are not just confined to products, but extend to prices

and delivery as well, which are important ingredients in their profitability

assessment; there is a need to take appropriate action on that front. The pricing

perspective implies that each competing bank must set fair and transparent prices

and they can attract customers and boost their profitability with good

deals. What’s more, the rising popularity of banking institutions to connect with

their customers at many several touch points is only a testimony that the

competitive battleground just got bigger!

f. Research Analysts: Commercial banking profitability studies highlighted in this

research work apply the structure-conduct performance (SCP) hypothesis to the

banking industry. According to the hypothesis, the degree of competition among

firms in a banking market is influenced by the degree of concentration of their

output (loans, assets and deposits) among a few relatively large banks, since a

more highly concentrated market structure is assumed to be conducive for more

effective collusion and hence enhanced profitability among the commercial banks

(Smirlock, Gilligan and Marshall, 1984; Molyneux, Lloyd-Williams and

Thornton, 1994; Mugume, 2010). However, a conflicting version of the Efficiency

Structure Hypothesis (ESH) postulates that an increase in banks’ profitability is

29

majorly attributable to the total efficiency improvement in its operations. In this

research work, this hypothesis will be tested by estimating measures for bank

performance (profitability) as a function of concentration and efficiency in the

local market. If the market share paradigm of the SCP reveals positive and more

substantial empirical support, authorities will be advised to put more emphasis on

promoting competition in the banking industry, regulating banking product prices

in the industry and generally discouraging further mergers of banks.

However, if the ESH theory which asserts that only efficient firms can attain an

increase in market share and hence their profitability because of their superiority

in producing and marketing products then authorities will be expected to put more

emphasis on promoting competition in the banking industry and discouraging

further banking consolidation reforms (Demsetz, 1973). Therefore, a resolution of

these conflicting theories, as attempted in this research work is a veritable ground

for further research analysis especially for developing countries in Africa.

1.8 Limitations of the Study

Conducting a research project of this nature may not be totally complete without

stating some obvious limitations. The major limitation in this research is the use of

secondary data which may inherently contain errors that can affect the validity of our

own research findings, recommendations and suggestions. This limitation is

highlighted here for obvious reasons.

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CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1 Introduction

In recent years we have witnessed a substantial convergence of research interest and

the opening of a debate on the economic role of market competition in the banking

industry. The need for such a debate may seem unjustified at first but common

wisdom will hold that restraining competitive market forces from interacting will

unequivocally produce welfare losses (Simpasa, 2013). Banks with monopoly power

will exercise their ability to extract rents (installmental interest receipts) by charging

higher loan interest rates to businesses and by paying a lower rate of return to

depositors.

37

Higher lending rates will distort entrepreneurial incentives toward the undertaking of

excessively risky projects, thus weakening the stability of credit markets and

increasing the likelihood of systemic failures. Higher lending rates could also limit

firms’ investments in research and development, thus slowing down the pace of

technological innovation and productivity growth. On the other hand, a lower supply

of loanable funds, which is often associated with higher lending rates, should also be

reflected in a slower process of capital accumulation and therefore, in a lack of

convergence to the highest levels of income per capita (Simpasa, 2013). These are

some of the conventional effects that market share in the banking industry is

commonly known to generate.

However, in more recent years, researchers have begun analyzing additional issues in

the matter of bank competition, highlighting potentially negative aspects and so

raising doubts regarding the overall beneficial welfare impact of bank competition on

the economy. The research efforts devoted to this issue has increased tremendously

within the last decade, a sign that the time is ripe for an open debate regarding the

costs and benefits of bank competition. A key assumption in much of the literature

used in this research work is that banks are generally in this business to maximize

profits.

It is in fact one of the (few) assumptions that is shared by almost all the models that

were reviewed for the purpose of completing this work. At this point in our

discussion of the impact of competition in the profitability of commercial banks in

Nigeria, it is instructive to remind ourselves of exactly why banks should maximize

their profits. To be sure, standard theory tells us that a bank’s shareholders are the

principal claimants to its profits and it is therefore in their interest to maximize these

profits. Commercial banks will maximize their returns on investment by maximizing

their revenues and by minimizing costs (Berger and Hannan, 1998). Banks are a

service industry. They contribute to the economic growth of the country not by

producing real goods, but by providing the financial means to facilitate the production

of goods in other industries (Allen and Gale, 2004a).

Therefore, an efficient banking sector should make one of the largest contributions to

the nation’s economic growth. As in other industries, the degree of competition in the

banking industry can matter for the efficiency in the provision of financial services,

38

the quality of financial products, and the degree of innovation in the banking sector.

Specific to the financial sector is the link between competition and profitability, long

recognized in theoretical and empirical research and most importantly, in the actual

conduct of prudential policies towards banks (Vivex, 2001; Classens and Laeven,

2004; Berger and Hannan, 1989; Allen and Gale, 2004b). The impact of competition

in the banking system should be measured with respect to the actual behavior of

commercial banks in relationship to their profitability. There are three broad issues

related to studying the impact of competition on the performance of commercial

banks. These according to Bikker and Haaf, (2001) are:

1. Do we need a competition policy to be formally put in place as a strategy

document to guide the operations of commercial banking in Nigeria? If we do,

2. What might be the possible coverage of the competition strategy policy?

3. How will such a policy relate to the broader economic objective of enhancing

commercial banking profitability?

In this literature review, we intend to review the relevant literature that will enable us

answer all the questions and more under 2 major headings: theoretical review of

relevant literature and the empirical review which will highlight some of the recorded

statistics, that are attributable to assessing the impact of competition on the

profitability of commercial banks in Nigeria.

2.2 Theoretical Review of related Literature

The impact of changes in bank performances (profitability) has been the focus of

considerable scholarly effort during the past decade. Most of the studies have taken a

cross section of different banking markets, applied a multiple regression technique to

their performances (profitability) just to isolate the effect of changes in market share

on bank performance and then used the resultant coefficient of the H statistic to

determine the impact of competition in a given market as was postulated in the market

structure model of Panzar and Rosse (1982). The H statistic as adopted in this

research work therefore, is the coefficient of the proxies of competition, such as

market share, efficiency and concentration on the profitability of banking

performances analyzed using a multiple regression technique. In general, the results

of previous researchers indicate that changes in market share affect both the pricing of

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banking products and the quality of banking services provided to customers, but that

their impact on banking profitability is quite small. However, there are so many other

contradictory results that have also been obtained in similar studies.

Our present jet age and the resulting euphoria in the market place have placed the

ultimate weapon of conviction in the hands of the marketers of banking products and

services hence driving banking competition and ultimately efficiency. Banking

efficiency is instrumental to economic development (Barajas, et al., 2000).

Inefficiencies in the financial systems of most developing countries have persisted

even though many of these countries have undertaken financial reforms over the past

two decades or so. Gilbert (1984) observe that in many Sub-Saharan Africa (SSA)

countries the range of financial products remain extremely limited, interest rate

spreads are wide, capital adequacy ratios are often insufficient, loan recovery is a

problem and the share of non-performing loans is large. The expectation is that

removing government controls on interest rates and lifting barriers to entry into the

financial system would lead to greater competition and improve performance of the

financial institutions. A number of studies have also argued that unless banks’

behavior changes, the financial reforms that most of the developing countries have

implemented cannot lead to a significant improvement in the efficiency of their

financial systems (Gibson and Tsakalotos, 1994; Barajas, Steiner and Salazar, 2000).

We can deduce several explanations for these limited changes in the financial system

efficiency of these countries following these financial reforms:

First, following Bain’s market structure, conduct and performance (SCP) hypothesis

in the industrial organization which has been widely applied in the banking industry

(Bain, 1951), it postulated that poor banking performance may continue to persist if

financial sector reforms do not significantly alter the structure within which banks

operate. The interpretation here is that, for financial reforms to be effective in most of

these developing countries, including Nigeria, the financial institutions must

significantly alter their market structures to enhance their acquisition of a larger

market share. As a confirmation of the above theory, a recent research by Gibson and

Tsakalotos (1994) have pointed out that the impact of competition resulting from

conditions of free entry and competitive pricing will raise the functional efficiency of

intermediation by decreasing the spread between deposits and lending rates.

Although, the empirical evidence of a positive and significant relationship existing

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between market share and banks’ profitability yields non-robust results, there is

compelling evidence to suggest that market share plays an important role in altering

the performance of commercial banks (Gilbert, 1984; Berger and Hannan, 1989;

Molyneux and Forbes, 1995; Demirguc-Kunt and Huizinga, 1999). The most recent

literature on the impact of banking reforms and financial liberalization on profitability

by Barajas et al., (1999, 2000) also supports the hypothesis that commercial banks’

profitability indicators are positively related to market share.

Secondly, the removal of credit controls during financial reforms which may worsen

the quality of loans, may in turn lead to increased risks of systemic crises and

decrease commercial banking profitability arising from changes in the financial

system efficiency of countries following financial reforms:. Brownbridge and

Kirkpatrick (2000) note that liberalization of interest rates and removal of credit

controls as measures of banking reforms may allow commercial banks that are not

constrained by prudential regulations to begin to invest in risky assets in order to

maintain larger market shares and hence enhance their profitability indicators. This

may reduce the quality of loans and may result in a higher proportion of non-

performing loans and provisions for doubtful debts. Banks tend to offset the cost of

screening and monitoring attributable to bad loans or the cost of forgone interest

revenue by charging higher lending rates (Barajas and Salazar, 1999; 2000). These

responses as a result of banking reforms are most likely to affect the banking sector’s

profitability.

The works of Barajas and Salazar (1999, 2000) also found support for the positive and

significant relationship existing between poor bank performances (Lower

profitability) and provisions for doubtful debts in some Caribbean countries. They

further confirm that the cost of poor quality loans is usually shifted to bank customers

through higher spreads in the Caribbean countries e.g. Colombia. Their works also

found a significant and negative relationship existing between poor bank performance

and provisions for doubtful debts in other Caribbean countries such as Argentina and

Peru. (Barajas and Salazar, 1999; 2000). These are evidences from countries that have

recently implemented financial reforms in their systems.

Thirdly, there is overwhelming theoretical evidence that high non-financial costs

resulting from banking reforms are also a source of persistent inefficiency in the

banking sector in developing countries such as Nigeria. Non-financial costs reflect

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variations in physical capital costs, employment and wage levels. High non-financial

costs may result from inefficiency in bank operations that may also be shifted to bank

customers, particularly in imperfect markets, thereby impacting on the profitability of

commercial banks. Dermirguc-Kunt and Huizinga (1999) in their analysis found

evidence of a negative relationship existing between banks profitability and overhead

costs – operational expenses for firms in industries that have recently implemented

financial reforms. This relationship was also confirmed by Barajas and Salazar in

their works (Barajas and Salazar, 1999; 2000) when they reported a significant and

positive relationship existing between banking inefficiency and non-financial costs

even for countries that have recently implemented financial reforms.

Fourthly, macroeconomic instability and the policy environment may also affect the

pricing behavior of commercial banks after banking reforms and therefore impact on

their profitability. In order to capture the effects of the macroeconomic and policy

environment, the banks’ profitability equations must include inflation, growth of

output market, growth of the money market, real interest rates as control variables.

For example, Claessens et al. (2001), Dermirguc-Kunt and Huizinga (1999), and

Brock and Rojas-Suarez (2000) note that banking industry performance and inflation

are negatively associated. In Nigeria, ambitious financial reforms were initiated in the

economy specifically between 2004 and 2007 that were aimed at: (Nannyonjo, 2012)

Redefining the structure and operations of the financial institutions

Easing of entry requirements for foreign banks

Limiting mandatory investments

Reducing the reserve requirement ratio

Phasing out direct monetary policies

Privatizing the state-owned financial institutions and

Strengthening prudential norms.

In particular, a weak financial industry limits the efficient aggregation and allocation

of resources and subsequently causes wastes in those sectors and enterprises that are

less well linked into the financial pipelines. Moreover, the recent reforms,

(Nannyonjo, 2012) particularly within the banking system, may have resulted in a

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sound, competitive and efficient system that can deliver on greater access and

financial deepening with an overall increase in the sector’s profitability. Nigeria’s

banking industry is undergoing unprecedented changes, caused by the deregulation of

financial services, strengthening of regulatory and supervisory frameworks and

developments in information technology. An integral part of the process has been the

liberalization of international capital movements. Many of these changes could have

had vast implications for competition and concentration in the banking and financial

sectors. The combination of improvements and unfulfilled potential warrants this new

look at Nigeria’s banking sector. One of the advantages has been mergers and buyouts

which has increased concentration.

In summary, whilst financial reforms should generally lead to improved banking

sector performance, whether actual improvement really occurs will depend on a

number of other exogenous factors such as the pricing of bank product, the behavior

of customers, banking regulations, etc. Generally, banks’ efficiency can increase or

remain low depending on the competitiveness of the banking system, the cost

structure of the market, the sophistication of the banking system and the

macroeconomic environment. According to the literature on industrial organization,

(which has been severally applied in the banking industry) as was postulated by Bain

(1951) there are two main explanations for the likely impact of market share on the

conduct and performance of firms. These are market share and efficiency.

The market power theory has two hypotheses: the structure-conduct performance

(SCP) hypothesis and the Relative Market Power (RMP) hypothesis. The traditional

structure-conduct-performance hypothesis is based on the proposition that the

persistence of financial profits is indicative of distortions in allocating resources in the

economy which are due to some features of market structure that foster collusion and

retard competition among firms in the industry (Bain, 1951). Since concentration

facilitates collusive or monopolistic practices, firms in concentrated markets will earn

higher profits than firms operating in less concentrated markets irrespective of their

efficiency. This hypothesis suggests that banks in concentrated markets would be able

to extract monopolistic rents (periodic receipts of interest income) by their ability to

offer lower deposit rates and higher loan rates (Bain, 1951). For its part, the relative

market power hypothesis (RMP) states that only firms with large market shares and

well-differentiated products are able to exercise market power in pricing their

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products and earning supernormal profits (Shepherd, 1986). A number of studies have

either applied the Bresnahan methodology or the Panzar and Rosse methodology to

the issue of competition in the financial services sector, specifically in the banking

industry.

For example, Shaffer (1989) used the Bresnahan model to study the impact of

competition on a sample of US banks and found results that strongly reject collusive

conduct among competing banks but noted that banks whose conduct were consistent

with perfect competitive behaviors had significant and positive relationship between

competition and profitability. Again using the same Bresnahan model, Shaffer (1993)

found that the Canadian banking system was also competitive over the period 1965 –

1989, although, their banks were relatively concentrated. Also, Shaffer (2001) used

the same Bresnahan model to study the impact of competition on the profitability of

banks for 15 countries in North America, Europe, and Asia during 1979 – 1991 period

and found a significant and positive relationship existing between the market share

and profitability in 5 markets and excess capacity in only 1 market. These findings are

consistent with the findings of Shaffer (1982) when he applied the Panzar and Rosse

methodology (P–R multiple regression model) to a sample of New York banks using

bank panel data for 1979 and found that monopolistic competition existed in New

York banks.

However, Nathan and Neave (1989) who also studied a sample of Canadian banks

using the P-R methodology found results inconsistent with the results of Shaffer

(1989) using the Bresnahan methodology, i.e., a rejection of monopoly power in

banking markets which connotes collusive behaviors. Several other authors have

applied the P-R multiple regression methodology to European banking system

(Molyneux et al., 1994; De Bandt and Davis, 2000) and obtained results similar to the

ones of Shaffer (1989) and Nathan and Neave (1989). Generally, these studies reject

both perfect collusion and perfect competition as having significant impact on the

profitability of banks but find significant and positive evidence of monopolistic

competition. Tests on the competitiveness of banking systems for developing

countries such as Nigeria and other transition economies using the Bresnahan and

Panzar – Rosse models are few to date as compared to tests using the P-R

methodology in developed countries.

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2.2.1 Market Share Models:

In distinguishing the types of competition that firms can engage in, the Panzar-Rosse

multiple regression model was adopted in the research works of Bikker and

Groeneveld (2000) and Bikker and Haaf (2002) to determine a dependency of mar