Competition for banks helps economic growth

via CAAI

Tuesday, 12 October 2010 15:01 Heng Dyna

Dear Editor,

When Cambodian Public Bank (Campu Bank) announced that it would offer 6 percent annual interest on loans, other leading bankers expressed their concerns that the new offer would undercut market rates and raise the possibility of a credit war. Competition is generally a good thing, but is it really the case in the banking industry?

Some argue that restrained competition means high lending rates and less credit quantity for investment. Leading banks with more market power would exercise their ability to charge higher interest rate on loans, which distort entrepreneurs’ incentives to invest in new businesses, business expansion, or research and development projects. Consequently, we would face a slow pace of innovation and productivity growth, and thus slower economic growth.

Banking competition, on the other hand, is said to be beneficial in business expansion and development projects promoting small and medium enterprises. It could produce lower interest rates, increase funds available for investment and raise incentives for banks to offer market-based and demand-oriented financial products and services at lower costs. Competition would extend outreach to rural areas while lower interest rates would provide more incentives for businesses in urban as well as rural areas to invest and produce more, which promotes faster economic growth.

However, due to special characteristics of the banking business, competition might not be purely positive, driving down costs and rates and enhancing efficiency as claimed. Although competition is likely to lead to a larger quantity of loans, there could be potential negative effects from banking competition.

First, more loans does not necessarily mean more profitable business, as business success depends more on a conducive business environment and entrepreneurs’ capability.

Second, if banks expect a lower stream of profits in the future due to intense competition, then their incentive to take risks would increase.

Consequently, there may be a higher rate of defaults and thus greater waste of resources. This negative effect could hurt the financial stability of individual banks and the stability of the banking system as a whole. There is indeed a well-established line of thinking among bank regulators in many countries such as Canada and Australia that a less competitive industry leads to a more stable financial system.

A well-function banking sector can be one of the most powerful tools for fighting poverty and for speeding up Cambodia’s economic growth by supplying financial services to lower-income households and young entrepreneurs, and by fuelling business expansion. Given the current stage of our banking competition and financial development, I would argue that competition is necessary and beneficial to create a more efficient banking sector to allocate capital resources for the most productive uses. Meanwhile, the greater competition itself should be accompanied by more stringent regulation, particularly in credit rationing and monitoring, risk management and information gathering.

Heng Dyna

Canberra, Australia