Economic Rationale behind Oligopolistic Behaviour in Banking Sector - Essay Example

?Economic Table of Contents 0 Introduction 3 The next section talks about the economic rationale which drives firms comprising the banking sector to build an oligopolistic market framework; there are special references to empirical evidences from different nations in this regard as well. The third section is an illustration of the implication that an oligopolistic banking sector is likely to have over the residents of a nation. The fourth section depicts the situation in Australia where nationals have been immensely protesting against the oligopolistic banking sector and finally the last section summarises the contents of the entire paper. 3 2.0 Economic Rationale behind Oligopolistic Behaviour in Banking Sector 4 3.0 Implications of an Oligopolistic Banking Sector on Consumers 7 4.0 Situation with the Australian Banking Sector 9 5.0 Conclusion 9 References 10 1.0 Introduction An oligopolistic market structure is characterised by a few sellers in the market but a large number of buyers. These contending firms are highly interdependent upon each other to strengthen their market status and hence, frame schemes to facilitate the same. Some of the commonest strategies include competition on prices and quantities being marketed by the firms1. In addition to competing with their peers, the firms also assume the role of creating artificial barriers, in the form of hefty license fees, to prevent the entry of potential competitors within the industry to restrict the number of market players. Such artificial regulations might be beneficial for the existing firms in the business though the purchasers always end up at the worse side of things as lack of ample competition reduces the degree of consumer surplus that they could have enjoyed. The present paper takes up the case of the banking sector and attempts to emphasise the implications of oligopolistic market structure on bank customers. In addition, the research tries to assess the economic rationale underlying the oligopolistic behaviour of bankers. It takes up the case of Australia at the end where consumers have protested the market of the banking sector and evaluates the justification of such a rebellion. The next section talks about the economic rationale which drives firms comprising the banking sector to build an oligopolistic market framework; there are special references to empirical evidences from different nations in this regard as well. The third section is an illustration of the implication that an oligopolistic banking sector is likely to have over the residents of a nation. The fourth section depicts the situation in Australia where nationals have been immensely protesting against the oligopolistic banking sector and finally the last section summarises the contents of the entire paper. 2.0 Economic Rationale behind Oligopolistic Behaviour in Banking Sector A few advantages based on the economics of business are the reasons why firms tend to operate as an oligopolistic market. Those very factors could be applied to the banking sector as the reasons why the industry chooses to operate under such environment. Firstly, oligopolistic market structure makes room for economies of scale which associates huge amount of profit with each operating unit, owing to reduced average cost of production as the diagram alongside depicts. As the diagram shows, the average cost of production falls with rise in the quantity produced, though this reduction does not continue for very high quantities. The point where the combination of cost and quantity to be produced is found to be the optimal, i.e., highest production at the lowest cost, is the chosen one by the sellers. In the above diagram, this point coincides with E1 where the quantity to be produced is Q1 and the associated average cost is the lowest at AC1. This is one of the reasons why the larger existing firms restrict new entrants from moving into the industry. The smaller firms in the industry are often acquired by the larger to clear their path towards experiencing economies of scale. This in fact had been the case in USA where the banking industry had been solidifying since 2003 in order to reduce the extent of competition which could prove to be self-destructive, in addition to lowering the average cost of operation. Such a move in the nation reduced the number of commercial banks from more than 14,000 to a little above 7,500 between 1985 and 20042. There are other ways as well by which banks make it possible to reduce competition in the industry. In Bulgaria, for example, when the Bulgarian National Bank decided to split up to a number of individual commercial banks, it was anticipated that the monopoly structure would be converted into a competitive structure. Nevertheless, this was not found to be the case since these banks had not yet developed a branch network. Similar is the case with that of Czechoslovakia and Poland although both these nations had contained a number of commercial banks from the very beginning unlike that of Bulgaria3. Secondly, an oligopolistic market structure also helps to assimilate managerial expertise and employee efficiency unlike that in case of a competitive market environment. Such a market structure keeps the limited resources available in an economy restricted within a few organisations so that each of them is endowed with a huge amount of the same. Furthermore, as the number of institutions where the creamy layer of employees has to be recruited is limited, the employers enjoy the benefit of selecting only the best of the lot. Again these employees are subjected to intensive training programs to train them in performing their duties appropriately. In case that they fail to satisfy their employers, the latter always have an option to dismiss them and recruit a new bunch without having to compromise on the quality of service being provided4. Technological investment is a third factor which is associated with the benefits of an oligopolistic market structure underlying the banking sector. Such an instance could be found from the case of USA where domestic commercial banks had been subjected to regional restrictions which prohibited them to operate beyond a certain boundary; since non-bank financial institutions did not have such restrictions imposed over them, they easily turned up as potential competitors of the former. However, as the number of commercial banks operating in the market had been small, it had been easier to invest substantially for technological progress of the same which later helped them to bail out of their submissive situation5. In addition, as the case had been in case of Brazilian banks, the national administration preferred to promote the bigger banks which already had been equipped with a certain degree of competence in them to face foreign competition6. Financial robustness and stability is another important reason which gives the oligopolistic market structure an edge over other forms of market. Given the small number of players in a particular sector, the accumulation of profit is quite high with each of the underlying units. Hence, it helps to build up the financial robustness of the concerned sector which actually is very essential for the banking sector since it is the one which financially supports an economy. Accrual of profit with each unit could be cited as one of the reasons why oligopolistic market structure can encourage research and development in an economy. With a profit amounting to a larger volume than that in case of a competitive market structure, each individual firm can invest more and more in innovating ways to attract more customers, providing them with a better quality of service and thus, building a larger consumer base. In fact, this is the very method followed by the Brazilian banking sector not only for facilitating technological progress but also to improve financial competence in the international community7. Lastly, brand name is an important factor which helps people to distinguish a company from a group of others. People often associate a variety of factors such as quality of service or trust with the image of a company which again is created through a prolonged period of unprecedented establishment. This fact is especially important in the banking sector where people deposit their resources with a hope of security. Image of a firm associated with long years of service and helps to carry on with the same over a span of many years to come. In case that competition is allowed in such an industry, brand name of an organisation loses its importance by a large extent and hence, begins to lack its recognition. Furthermore, higher the degree of competition that banks are subjected to, higher will be the pressure on them to excel in their respective fields of operation. However, in the absence of many competitors, people tend to stick back with their old banks despite posing many complaints against them. This is a case of “apathetic loyalty” which had been found among UK bank customers. Despite their allegations against their banks, people stick back to the former owing to the image the company had impressed upon its customers over a long span of service8. Thus, banks have pretty many reasons to support an oligopolistic market structure, with their causes being those of economies of scale, amalgamation of skilled resources, assistance in technological investments, financial robustness arising out of substantial profit incurred by each unit and image of products9. However, in contrast to the advantages that banks enjoy out of such a system, the bank customers have little to enjoy out of the same. Implications of such an organisational structure over bank customers have been enlisted in the following section. 3.0 Implications of an Oligopolistic Banking Sector on Consumers Oligopolistic market structure is rarely supported by bank customers as it retards competition in the sector thereby deducting the degree of consumer surplus. Such a system is especially discouraged when possibilities of cartels exist between underlying firms in the industry. However cartels are illegal as per the rulings of domestic anti-trust laws though the same is not true for business solutions such as mergers and acquisitions. Such moves frequented by the banking sector of Denmark actually led to the establishment of one large bank in the nation which experienced high profitability figures over time. This raised concern among Danish bank customers who complained of lacking competition in the industry. Due to absence of suitable competition in the industry, the bank dominating over the market started charging illicit commissions and fees which lack ample transparency, thus victimising the bank customers. On the other hand, these customers had practically no place to go which bonded them to the only large bank of the economy with the knowledge of being cheated at every stage of operation10. Mergers or acquisitions help to enlarge the economies of scale of operation of banks, as had been anticipated by the Secretary of State of Scotland in 2001 when Lloyds planned an acquisition of Abbey National. The decision of 2001 indeed came as a boon for customers who enjoyed banking services at nominal fees, which actually helped in the restoration of financial stability in the nation. However, later in 2009, when Lloyds merged with HBOS, the merged entity used its powers to extract hefty commission payments out of its consumers11. Thus, implications of an oligopolistic banking structure could either improve or worsen the situation of consumers, depending upon the intentions of the bank. Sometimes, illicit cartels and collusions can indeed exist between banks so as to minimise even the slight amount of competition which exists between market players thus instigating them to frame methods of attracting consumers to themselves. Given that products which banks deal with are unique in nature, there remains some space for competitive practices. Cartel solutions could be an easy answer to minimise such competitive forces in the market. As the underlying diagram shows, such solutions instigate producers to produce at points where their reaction curves are tangent to each other rather than at points where they intersect. The diagram demarcates those points where the reaction curves of firms are tangent to each other which symbolise the points where the firms must produce in order to maximise their individual profits while still in a cartel. In the absence of a cartel, these two firms would have produced Y1* and Y2* respectively, i.e., they would have placed themselves at a point where their respective optimal reaction curves intersect. However, now the point where they are likely to produce depends upon the condition for joint profit. The latter case produces higher market output and hence drives the market price lower unlike that in the case of the former, which results to a higher profit12. However, as collusive practices are illegal as per the domestic anti-trust laws in a nation, examples of the same are difficult to come by. The unlawful nature of such collusive activities has initiated a probe into the nature of activities of some of the major banks of USA, such as Citigroup and Bank of America, by investigators who suspect an agreement upon the key interest rate13. Similar is the case with the Moroccan banking system which acts as a cooperative oligopoly and fixes some amount of rent to be extracted out of the cartel14. If the apex central bank of a nation too participates in such activities, the foreign exchange rate of the domestic currency could be artificially regulated too so that the said nation is involved in fraudulent practices by means of entering into a worldwide collusion with the global banking sector15. On the other hand, an overcrowding in the banking sector could drive up the cost of operation of the banking units by a large extent. The proportion of fixed cost that they have to bear out of aggregate revenues which they earn, often decides the rate at which they pay interests to their depositors. As competition compels the banks to charge lower banking fees in addition to an already insignificant market share, the amount that they earn as revenues is quite small though the volume of fixed costs they need to bear isn’t. This is the reason why banks operating in a competitive environment are likely to pay lower rates of interests in lieu of deposits than an oligopolistic firm could afford. This essentially is the outcome being arrived upon by Cournot in his general equilibrium model for profit maximisation16. 4.0 Situation with the Australian Banking Sector The Australian banking sector is characterised by an oligopolistic structure with four major financial institutions and each of them featured by a wide network of branches. Prior to 1970s, traditional banks in Australia did not have the right to accept deposits in lieu of interest payments though their role had been revised past 1971 when the traditional structure of the bank was modified to align their function with those of other non-bank financial institutions in the nation17. However, as their role was revised by the regulatory authority of the nation, it was necessary to regulate the functioning of the banking sector as too much competition often turned out to be detrimental for the banking sector’s objective of profit maximisation. This is the reason why the apex financial body in the nation restricted the provision of licenses as such to potential entrants in the sector post 1980. To be precise, only 16 commercial banks had been provided with a license to operate in the domestic financial sector in a span of two decades since 1980. Hence, the oligopolistic market structure of the Australian banking structure has not been hampered as such given the presence of four big financial houses each with a wide network of branches. In fact, as each one of them had already occupied a large share of the market, the 16 new entrants could pose little threat for the former’s operation18. 5.0 Conclusion An oligopolistic market structure is characterised by the presence of few sellers and a large number of buyers thus restricting the amount of competition which potentially could exist in a market. This is the very fact which leads to hefty profit earnings of the producers owing to large market shares enjoyed by each, in addition to the plights of consumers on account of low consumer surplus. Similar had been the case in the Australian banking sector which invited mass protests from the residents of the nation. The motive of these protestors had been to allow new entrants into the market so as to reduce the exploitation that the already existing banks had been imposing over Australians. However, absence of competition in the market might be beneficial for the economy as well, depending upon the nature of the commodity in question. This might be in accordance to the higher rates of interest that the banks are offering to their customers owing to the oligopolistic nature of the market. But it remains to be investigated further whether a competitive banking structure could actually prove advantageous for the oligopolistic banking sector of Australia as per the claims of people. References Aoki, M., and H. T. Patrick. The Japanese main bank system Oxford: Oxford University Press, 1990. 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