Competitive conditions and market power of Islamic and conventional commercial banks

Competitive conditions andmarket power of Islamic and

conventional commercial banksHichem Hamza

Graduate School of Business of Tunis,Manouba University, Manouba, Tunisia and

Laboratory of Economy and Finance (ECSTRA),IHEC Carthage, Tunis, Tunisia, and

Safa KachtouliInstitute of Commercial High Studies of Tunis,

University of Tunis, Tunis, Tunisia

Abstract

Purpose – The expansion of the Islamic banking industry seems to accentuate thebanking competition in MENA and Southeast Asia where conventional and Islamic banks coexist. Inthis context, the research aims\ to examine the competitive conditions and the market power of theconventional and Islamic banks during the period 2004-2009 in MENA and Southeast Asia region.

Design/methodology/approach – The authors use a variety of structural and non-structuralmeasures related to the traditional approach and the new empirical approach of the industrialorganization. The methodology is based on set of measures of the competition and market power.The first measure is a set of concentration ratios (C3, C5) and Herfindahl-Hirschman index (HHI).The second measures are the Panzar and Ross H statistic and the Lerner index based on econometricestimations with the aim of evaluating the structure of market and measuring its power in terms ofprice setting.

Findings – The results indicate that under the HHI index, both markets are low concentrated, whileaccording to the concentration ratios, the Islamic market is considered as moderately concentrated.The estimations results, through the H-PR-statistic of Panzar and Ross related to degree of competitionand the Lerner index of market power, indicate that both markets are characterized by a monopolisticcompetition and the Islamic banking expressed a high degree of market power.

Research limitations/implications – The research focuses exclusively on the countries where thedata are available and excludes the other countries where competition and market power might havedifferent forms.

Practical implications – In a competitive environment, each bank is required to analyze thestructure of its market and competitive conditions, in order to develop a business strategy andeffective action plans. In the context of the multiplication of the Islamic banks in the MENA andSoutheast Asia, the enhancement of Islamic bank competitiveness by offering new products isdeterminant for their success.

Originality/value – To the best of the authors’ knowledge few studies have examined this subject ina comparative analysis between the Islamic and conventional banks. So the authors contribute to theliterature on Islamic banking by considering a sample of Islamic and conventional banks operating inthe same countries in order to examine the existence or not of difference between them.

Keywords Islamic banks, Bank competition, Lerner index, Market power

Paper type Research paper

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1759-0817.htm

Journal of Islamic Accounting andBusiness ResearchVol. 5 No. 1, 2014

pp. 29-46q Emerald Group Publishing Limited

1759-0817DOI 10.1108/JIABR-05-2012-0030

Competitiveconditions andmarket power

29

1. IntroductionThe Islamic banking industry is considered as a new shape of financial intermediation.Different from conventional system, the relationship between the Islamic banks and itscustomers is based on mutual trust, strengthened by shared religious beliefs. Thesebanks offer products in accordance with Fiqh Al Muamalet that encourage trading andproductive investment. The expansion of this industry is done through the increase ofthe value of its assets which were about $5 billion in 1985, and it is of a trillion dollarsin 2012. In some countries, Islamic banks cohabit with the conventional banks and facetogether the competitive conditions of the market. In this competitive environment,each bank is required to analyze the structure of its market and competitive conditions.The analysis and the measures of competitive conditions and market power shouldhelp the banks to develop a business strategy and effective diversification plans inorder to be more competitive. The measure of competition and market power of banksare topics that have generated much interest in the literature of industrial organization.

Conceptually, there are two approaches that examine the issue of competitiveconditions and market power. The first is the structural approach based on theparadigm of structure-conduct-performance (SCP) which establishes a causal relationfrom the structure of the market (concentration) to the performance of industries(profitability). The SCP stipulates that the performance of a firm is associated withmarket structure and conduct or behavior of a firm (Scherer and Ross, 1990). The SCPhypothesis supports that high concentrated firms are more competitive and profitableand have more market power in the framework of collusion. The SCP examines thecompetition conditions by using ratios of concentration of largest firms andHerfindahl-Hirschman index (HHI) index that characterize market structure.

Contrary to the traditional approach, the non-structural approach is based on newindustrial organization. This approach measures competition by using efficiencystructure (ES) hypothesis, it focuses on estimation of competition and market powerdirectly from the observed behavior or conduct of banks. The efficiency hypothesisstates that high efficiency of the bank helps in increasing its market share and realizingprofits. The competition measures used are the PR-H statistic of Panzar and Ross(1987) which provide an aggregate measure of competition, and the Lerner index whichprovide an individual measure of market power.

Several studies have investigated competitive conditions in the banking sector indifferent countries in the regions where the Islamic banks are in competition withconventional banks. In the region of MENA and Southeast Asia, we find Murjan andRuza (2002), Al-Muharrami et al. (2006), Abdul Majid and Sufian (2007), Berger et al.(2009), Turk Ariss (2010) and Weil (2011). We contribute to this literature on bankingindustry competition by considering a sample of Islamic and conventional commercialbanks operating in the same countries in order to examine the existence or not ofdifference between them. In fact, the Islamic and conventional commercial banks havesimilarities in term of financing activities. The study is between 2004 and 2009including the financial subprime crises which can have an impact on bankingcompetitiveness.

The main aim of this paper is to enhance the discussion about the competitiveconditions and the degree of market power of conventional and Islamic commercialbanks in MENA and Southeast Asia which are the great center of Islamic finance.Given the specificities of Islamic bank in term of financing and investment

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instruments, we propose to provide some answers to the competitive conditions in theIslamic and conventional banking and the type of market structure. For each type ofbank, the aim of comparison is to identify the market power or the capacity to sellproducts over the marginal cost which will indicate the distance between the price andthe marginal cost and the price setting.

Our paper will be divided into three sections: the next section presents thetheoretical concepts and a review of the literature. Section 3 presents the indicators andmeasurement methods of competition and market power. We use a variety of structuraland non-structural measures (ratios of concentration, HHI index, PR-H statistics andLerner index) to examine the bank competitiveness and the market power. Section 4discusses the comparative study of competition conditions on panel data of 62 Islamicbanks and 128 conventional banks from 2004 to 2009. Section 5 concludes.

2. Banking competition and market power: literature reviewThe measurement of competition can be divided into two major approaches: thestructural approach and the non-structural approach. The structural approach is basedon the traditional industrial organization literature and more precisely the SCPparadigm. The non-structural approach is based on new industrial organization, thisapproach measures competition by using ES hypothesis.

The paradigm SCP was developed by Mason (1939) in the University of Harvardthen pursued by Bain (1951, 1956). This paradigm is a descriptive approach of thefunctioning of the company stipulating that the performance of an industry and itscapacity to satisfy the needs of the consumers depends on the conduct of firms inother words of their behavior which is determined by the structure of the market.The approach SCP offers a causal link between the structure of a given market(concentrated or not), the behavior or conduct of the firms that operate in it (mainly interm of pricing) and the economic performances. The SCP is based on the hypothesesthat market structure influences conduct and conduct affects performance. Structuretherefore influences performance through concentration.

The SCP hypothesis argues that greater concentration causes less competitive bankconduct and leads to greater market power and profitability of the bank (Weil, 2011).According to this hypothesis, there is a positive relationship between the concentrationof the market and the performance measured by profits. Companies operating in themost concentrated sectors make profits more important than in industries lessconcentrated without taking into account their efficiency. Higher concentration wouldencourage collusion and reduce efficiency. The increase of the concentration of amarket implies collusion between the dominant banks which strengthens the power ofmarket of each of them. The collusion between banks can take the shape of a marketsharing or the maintain of a high prices which engenders a decrease of competition andthe obtaining of the profits higher than in even monopolistic or normal competition.According to the SCP approach, the competition can be estimated by diverse measuresincluding market shares, ratios of concentrations of the groups of the most importantbanks and the HHI. SCP paradigm is criticized on the assumption that causality is fromstructure to performance, although it is argued that conduct and performance canaffect market structure. Also, the limit of the traditional measures is that thecalculation of the degree of competition is done from indirect proxies such as marketstructure or market shares. Claessens and Laeven (2004) find that the actual behavior


31

of banks is related not only to market structure but also to other factors like entrybarriers, barriers on foreign ownership and activity restrictions which can limit thedegree of competition.

Since 1980s and as a response to the theoretical and empirical deficiencies of thestructural models, there was a development of the new empirical approach of theindustrial organization, pushed by a need of more precise and corresponding measuresof degree of competition and the market power. The new approach is based on thehypothesis of efficiency which stipulates that the performance of the company ispositively dependent on its efficiency. Indeed, the concentration of the market appearsfrom the competition where companies with lower costs increase their profits byreducing their prices and by developing their market shares. Thus, a positive relationbetween the profits of companies and the structure of the market is attributable to theearnings in terms of market share realized by the most efficient firms. These gainsengender an increase of the concentration of the market. As a consequence, the realizedprofits are the result of the efficiency of the company and not engendered by theanti-competitive behavior as suggested by the paradigm SCP. Efficiency hypothesisstates that if there is a positive relationship between concentration and bank profits orprices this can be explained by the superior operating efficiency of large banks.

The efficient firm may have some competitive advantages hence can increase itsmarket share and can realize higher performance. According to the efficiencyhypothesis, the performance of firms affects the structure of the market. The mostefficient banks increase their market shares to the detriment of the least efficientcompanies so that they engender an increase of the concentration of the market. Thequestion about a positive relationship between concentration and performance(measured whether by profits or prices) reflects collusion or efficiency has not resolvedempirically (Molyneux and Thornton, 1992; Berger, 1995; Goddard et al., 2007).

The new measures allow analyzing the behavior of companies in price fixation, aremainly based on the measures of market power and confirm that the prices aredetermined from the costs and not by the concentration of the market. The approach ofPanzar and Rosse (1987) measure the impact of the change in the average cost of thevarious factors of production on the income or the price under the condition that theindustry in question is in long-term equilibrium. The more the variations of the costsaffect the price, the more competitive is the market. In the same non-structuralapproach, the Lerner index (Lerner, 1934) is based on a valuable mark-up whichmeasures the difference between the price and the marginal cost. More the mark-up isimportant, bigger is the power of market.

On European and American data, among the studies using the statistics of Panzarand Rosse (1987) as measure of the structure of the market, we find that Shaffer (1989)is the first one to apply this technique to two under samples of American banks. Thefirst one observed during the period 1941-1975 and the second during the period1941-1983. The results obtained are coherent with the hypothesis of the existence of aperfect competition by rejecting strongly the existence of a structure of monopolisticcompetition. Berger (1995) finds some evidence that X-efficiency hypothesis holds inUS banking and the traditional SCP collusion hypothesis does not hold. Molyneux andForbes (1995) examined the concept of the SCP for banks observed between 1986 and1989 in 18 different countries. The study is an empirical recommendation for thetraditional concept SCP and stipulates that the degree of concentration influences the

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level of the competition in the banking industry. Claessens and Laeven (2004) realizedan important study of competition and concentration in the classic banking sector of asample which includes 50 developed countries during the period 1994-2001. By usingthe statistics H-PR, they concluded that the perfect competition describes each of thecountries studied in different degrees.

Murjan and Ruza (2002) studied the conditions of competition in nine countries ofthe MENA region during period 1993-1997. By using the Panzar and Rosse statistics,they show that the MENA banking sectors is under the conditions of monopolisticcompetition, and that the countries of the Gulf Cooperation Council (GCC) tend to beless competitive than the not oil-producing countries. Al-Muharrami et al. (2006) usedthese same indicators such as the ratios of concentration, the HHI and the Panzar andRosse H-PR statistics to study the structure of the banking industry in the Golfcountries and estimate the power of market of these banks during the period 1993-2002.The results show that Kuwait, Saudi Arabia and United Arab Emirates havemoderately concentrated banking markets and evolve towards less concentratedpositions and that their banks work in a regime of perfect competition. Whereas Qatar,Bahrain and Oman have very concentrated banking markets and their banks work inconditions of monopolistic competition.

Turk Ariss (2010) examines the conditions of competition in 12 countries of theMENA region during period 2000-2006 and tries to explain the differences in thedegrees of competition between the studied countries. Turk Ariss (2010) notes thatmost of the banking sectors of the region is under a monopolistic competition.Concerning the differences of competition degrees between the countries of the region,the author concludes that the indicators of contestability of the market and therestrictions of the activities are among the most important factors.

Anzoategui et al. (2010) studied the scale of the competition of banks in MENAduring the period 1994-2008. The authors used no-structural measures of thecompetition such as the H-PR statistics and the Lerner index. These two measuresindicate that the competition of the banking sector in the region is lower with regard tothe other regions and it did not improve during these last years. An analysis of thedeterminers of the competition in these countries suggests that the low levels ofcompetition are explained by the erroneous information on the environment of creditand the weak contestability of the market.

Weill (2010) examine a sample of bank in 17 countries of the MENA region and thecountries of the Southeast Asia observed over a period from 2000 to 2007. The authormeasures and compares the market power of the Islamic and classic banks bycalculating the Lerner index. The comparison of the Lerner index shows that there isno significant difference between the Islamic banks and those classics over the periodof study. By adding variables of control, the regression of the Lerner index suggeststhat the Islamic banks have less market power than the conventional banks. A test ofrobustness with the model of Panzar and Rosse (1987) confirms that the Islamic banksare not less competitive than their conventional peers.

The paper of Parera and Al. (2006) examined the nature of the competition and thestructure of the banking markets of four countries in the south Asia, Pakistan,Bangladesh, India and Sri Lanka for the period 1995-2003. The authors used the PR-Hstatistics and conclude that the banking income seems to be realized in conditions ofmonopolistic competition. For the Islamic banking sector in Malaysia, Abdul Majid


33

and Sufian (2007) indicate that market conditions are in monopolistic competition byusing traditional measures of the concentration as well as the method of Panzar andRosse (1987). Khan (2009) measured the degree of competition in the Pakistan bankingsector by using the non-structural approach of Panzar and Rosse (1987) in the contextof the contestability of the markets. A reduced equation of the income was estimatedby using panel data of 26 banks from 1997 to 2007. The various tests of the H-PRstatistics indicate that the banks in Pakistan operate in a situation of monopolisticcompetition.

3. MethodologyThe methodology is based on set of measures of the competition and market power.The first measure is a set of concentration ratios (C3, C5) and HHI index. The secondmeasures are the PR-H statistic and the Lerner index based on econometric estimationswith the aim of evaluating the structure of market and measuring its power in term ofprice setting.

3.1 Indicators of concentrationAccording to the traditional approach (SCP), the competition can be measured by theindications of concentrations or by the HHI. These two measures were widely appliedbefore 1990s and based on the market share. The ratios of concentration represent ameasure of the concentration of the market often used to illustrate the vast of thecontrol of the biggest firms of a given sector and identify the existence of anoligopolistic competition. A ratio of concentration is the percentage on behalf of marketof certain number of firms with regard to a sample given by the studied sector. Themost common rates of concentrations are the ratios C3 and C5 for the three and fivebigger firms of sample:

Cn ¼Xn

1

Xi

Cn ¼ S1 þ S2 þ · · · þ Sn

with:

Xi : the market share of the bank I.

n : the number of banks.

Sn : is the market share of the nth bank.

The ratios of concentrations vary from 0 to 100 percent and we distinguish four levelsof concentrations:

(1) No concentration. 0 percent it means the existence of a perfect competition or aless monopolistic competition.

(2) A low concentration. Between 0 and 50 percent this category goes from theperfect competition to the oligopoly.

(3) Average concentration. Between 50 and 70 percent the sector open to oligopoly.

(4) High concentration. Between 70 and 100 percent this category goes fromoligopoly to the monopoly.

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(5) Total concentration. 100 percent it is the case of an extremely concentratedoligopoly, and if CR 1 ¼ 100 percent there is a monopoly.

The HHI is another traditional measure of the competition and the concentration of themarket conceived by Hirschman (1945) and Herfindahl (1950). It is widely applied toestimate the level of competition of a market and its structure:

HHI ¼ S1 2 þ S22 þ S3 2 þ · · · þ Sn2

HHI ¼Xn

i¼1

Si2

where Sn is the market share of the nth bank.Si2 is the market shares of the company i and n is the number of companies.This indicator is calculated by adding the squares of the market shares of every

bank in the market or a country and it varies between zero (situation of pure andperfect competition) and 10,000 (1002: monopoly position). According to the AmericanMinistry of Justice and the Federal Trade Commission, a market in which the HHI islower than 1,000 points is considered as not concentrated, between 1,000 and 1,800 asmoderately concentrated, and above 1,800 as very concentrated.

The HHI takes into account the relative size and the distribution of companies in amarket and aims towards zero when the market consists of a large number of banks ofrelatively equal size. The more the value of the indication increases, the more themarket is concentrated, and weaker is the competition between the agents. The marketthus aims towards a monopoly position and an increase of the power of market. Thedecrease indicates the opposite.

3.2 Panzar and Rosse statisticPanzar and Rosse (1987) developed a test examining if the behavior at the level ofcompanies is in accordance either with the model of perfect competition, the model ofmonopolistic competition or the model of monopoly. This test is based on the empiricalexamination of the impact of the prices variations of the inputs on the income of thefirm. It is obtained by the sum of the price elasticity of the inputs.

The Panzar and Rosse H-statistics determines the competitive behavior of banks byusing an equation of reduced shape of income. The method generates plausible resultsif two necessary conditions are verified. The first condition requires that banks inquestion are in long-term equilibrium and the second requires that the performance ofbanks is influenced by the behavior of the other agents of the market. The calculationof the Panzar and Rosse H-statistics requires the estimation of the following function ofincome expressed on log:

LnðTRitÞ ¼ aþ b1LnðWL;itÞ þ b2LnðWF;itÞ þ b3ðWk;itÞ

þ g1LnðY1;itÞ þ g2LnðY2;itÞ þ 1it

ð1Þ

Variables used at the level of the function of income are defined as follows:

TRit : total income represented by the ratio of the interest income and otherdivided by the total assets.


35

WL,it : the labor cost represented by the ratio of the personnel spending to totalassets.

WF,it : the cost of funds represented by interest expenses to the total deposit.

WK,it : the cost of the fixed asset represented by the other administrative expensesto the total assets.

Y1,it : specific variable of control of the portfolio of the activities of the bankrepresented by total equity to assets.

Y2,it : specific variable of control of the portfolio of the activities of the bankrepresented by total loans to assets.

WL, WF and WK are the three entry price of the statistic H (H ¼ WL þ WF þ WK).Having estimated function (1), we can calculate the PR-H statistics which is

equal to:

H ¼X3

i¼1

bi

H ¼ 1, the market is characterized by perfect competition, i.e. an increase ininput costs will lead to an increase in marginal cost without affectingthe equilibrium of production.

H # 0, the market is a monopoly that is to say that an increase in entry costsleads to an increase in marginal costs which alters the equilibrium ofproduction and revenue.

0 , H , 1, the market is monopolistic competition that is to say that an increase ininput costs will lead to a less proportional increase of revenues.

The estimation of the function of income and the calculation of the PR-H statisticsrequires the check of the hypothesis of the long-term equilibrium. The approach ofthe test of equilibrium is almost the same that which for the calculation of theH-statistics. Indeed, the statistics of the test (E) is the sum of the coefficients ßi ofthe function:

LnðROAitÞ ¼ aþ b1LnðWL;itÞ þ b2LnðWF;itÞ þ b3ðWk;itÞ

þ g1LnðY1;itÞ þ g2LnðY2;itÞ þ 1it

ð2Þ

with:

E ¼X3

i¼1

bi

The interpretation of this statistic is as follows: a value of E significantly different fromzero implies that the market is not in equilibrium because in the long-term, the variationof the yields on assets does not relate to the variation of the prices of the inputs.However, in the presence of positive values of the PR-H statistics, Shaffer (2004)

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underlines that the rejection of the test of equilibrium does not distort the inferencesbased on the results of the estimation of this indicator. He also underlines that the noequilibrium suggests that the industry develops dynamically.

3.3 The Lerner index and the power of pricingThe market power can be considered as the capacity to sell products over the marginalcost. The Lerner index is one of the most popular and the oldest indexes of marketpower. It is a direct measure of competition through the distance between the price andthe marginal cost. The calculation of the index requires the estimation of the marginalcost of the product (equation (4)). Before this estimation, it is required the estimation ofthe function translog of the total cost by a model with fixed effects (equation (3)):

Ln costit ¼ b0 þ b1LnQit þb2

2Ln ðQ2

itÞX3

K¼1

gktLnðWk;itÞ þX3

k¼1

wkLnQit LnðWk;itÞ

þX3

k¼1

X3

j¼1

LnðWk;itÞLnðWj;itÞ þ 1it

ð3Þ

Cmit ¼Costit

Qitb1 þ b2LnQit þ

X3

k¼1

wkLnWk;it

" #ð4Þ

The variables used in the calculation of the marginal cost are:

Cost : the sum of the costs.

Qit : total asset of the bank i in time t.

WK : three input prices.

Lerner it ¼Pit 2 Cmit

PitPit ¼

1

1 2 L

� �Cmit ð5Þ

From this index, the firm can determine its level of mark-up ð1=ð1 2 LÞÞ. The Lernerindex is generally between 0 and 1.

Lerner index ¼ 0:mean a perfectly competitive behavior and the firm has no market power.

Lerner index close to 1:show the weakness of the competition at the price level and that the firm exercises amarket power thanks to a higher mark-up.

An increase of the index can be explained by two elements: either the price increase ora decrease of the marginal cost of the company. Generally the index provides positivevalues lower than the unit. However, it can register negative values which can beexplained as a consequence of a very strong competition obliging the firms to proposea price lower than the marginal cost (Maudos and Fernandez de Guevara, 2006), or theycan correspond to the period of introduction on the market which is characterized by avery high rate of charges.


37

4. Data, estimation and resultsIn this research on competitive conditions and the degree of market power in bankingindustry, the sample considers the Islamic and conventional commercial banks operatingin the same countries in order to examine the differences between them. For moreaccuracy of our selection procedure, all data were collected directly from financial reportsand verified in the Bankscope database during the period 2004-2009. Specifically, forIslamic banks, our procedure of data collection is as follow: From the sources of datamentioned above, 389 Islamic banks are retained. Because we exclusively focus oncommercial banks, investment banks and conventional banks with Islamic window areexcluded. The Islamic windows cannot be selected because data on conventional andIslamic products are grouped into the same financial statements. After this initialscreening, we obtain 123 Islamic deposit banks. From this number, we retain only62 banks for which data exist for all period like conventional banks retained. Thissample seems to be fairly representative because it includes the main centers of Islamicfinance, namely Malaysia, Bahrain and Pakistan. Table I presents the studied panelwhich includes 62 Islamic banks and 128 conventional banks operating in 18 countries(MENA and Southeast Asia). Our study focuses only on the commercial bank.

Table II presents a comparison of the annual averages of the following ratios: totalasset, the loans to total asset (L/TA), to total assets (E/TA), the return on assets (ROA)and the return on equity (ROE).

The table shows a remarkable increase in size of Islamic banks between 2000 and2009. However, the assets of Islamic banks remain less than those of conventionalbanks. During the period of study, the average of the ratio of the loans to total asset ofthe Islamic banks is 58.34 percent against 54.63 percent for the conventional. TheIslamic banks loans are essentially the operation of sale and leasing and theirpercentage is high relative to investment operations. The average of the ratio equity tototal assets is 17.88 and 10.98 percent, respectively. This indicates that the Islamicbanks are better capitalized than the conventional banks.

Country Islamic banks Conventional banks All banks

Saudi Arabia 3 7 10Bahrain 5 3 8Bangladesh 5 18 23Egypt 2 7 9Indonesia 3 3 6Iran 3 4 7Jordan 2 8 10Kuwait 3 6 9Malaysia 11 15 26Pakistan 6 3 9Palestine 1 1 2Qatar 2 5 7Sudan 3 2 5Thailand 1 9 10Turkey 4 17 21UAE 4 14 18Yemen 3 4 7Total 62 128 190

Table I.Distribution of Islamicand conventional banksby country

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In terms of measures of profitability there is no significant difference between bothtypes of banks, the averages of the ROA of the Islamic banks and the conventionalbanks are, respectively, 1.80 and 2.00 percent. Although they are less capitalized, theequity of the conventional banks generates more profit than those of the Islamic banks,perhaps due to the leverage effect. The average of the ratio ROE, for studied period,is 15.21 percent for the Islamic banks and 19.60 percent for the other banks. Theseresults can explain that Islamic banks are less competitive and risky than theconventional banks.

4.1 Traditional indicators of concentration and competitionTables III and IV illustrate a comparison of the ratios of concentration C3 and C5 ofboth markets from 2004 to 2009. Table V illustrates a comparison of the HHI indexes.

For the conventional market, the average of the values of the ratio C3 for the totalassets, the total of the deposits and the total loans is situated between 14 and 20 percent.These values of concentration belong to the range (0-50 percent). All values do notexceed the 20 percent what implies that this market knows a very low concentrationand a high fragmentation, in other words, in the conventional banking market eachbank has a reduced market shares. In the case of Islamic market, the average of thevalues of the ratio C3 for the total assets, the total deposits and the total loans, varybetween 36 and 39 percent and are higher than the values of the conventional market.However, the values of three ratios of concentration belong to the interval (0-50 percent).These values indicate that the concentration of this market weakens from one year to

Year TAL/TA E/TA ROA ROE

Market Islam. Conv.Islam.

%Conv.

%Islam.

%Conv.

%Islam.

%Conv.

%Islam.

%Conv.

%

2004 2,651 6,896 59.79 50.97 18.90 11.85 1.17 2.55 11.17 20.802005 3,514 8,217 56.53 54.14 19.03 11.67 2.42 2.61 19.99 19.662006 3,623 10,008 56.65 54.92 19.59 10.67 2.08 1.86 19.96 22.732007 5,043 12,974 62.26 54.25 17.94 10.51 2.42 1.89 16.49 25.762008 6,182 15,046 57.48 57.42 16.49 10.52 1.84 1.71 14.52 15.062009 6,830 15,487 57.32 56.09 15.31 10.63 0.87 1.42 9.14 13.57Average 4,640 11,438 58.34 54.63 17.88 10.98 1.80 2.00 15.21 19.60

Table II.Comparison of the

descriptive statisticsbetween both market

C3 total assets C3 deposits C3 loansYear Islam. M Conv. M Islam. M Conv. M Islam. M Conv. M

2004 0.4340 0.1516 0.4120 0.1561 0.4652 0.19702005 0.3937 0.1499 0.3615 0.1561 0.4120 0.18492006 0.3608 0.1471 0.3390 0.1456 0.3745 0.17912007 0.3267 0.1349 0.3183 0.1261 0.3514 0.16272008 0.3440 0.1309 0.3310 0.1283 0.3507 0.14152009 0.3260 0.1646 0.3105 0.1687 0.3596 0.1625Average 0.3642 0.1465 0.3454 0.1468 0.3856 0.1713

Note: For the Islamic banks, the total loan indicates the activities of financing (financing activities)

Table III.Ratios of concentration

C3 according to the totalasset, total deposits and

total loans


39

another and its fragmentation becomes more marked, this leads to conclude that theIslamic market knows an important expansion due to the entry of new banks.

The analysis of the ratios of concentration of conventional market shows that theaverage of the values of the ratio C5 is situated between 22 and 25 percent. The valuescalculated belong to the interval (0.50 percent) and do not exceed 29 percent. Thismarket is thus characterized by a weak concentration. For the Islamic market, averageof the values of the ratio C5 is situated between 50 and 56 percent. We see that most ofthe values fit meanwhile (50-70) and are decreasing in the time what reflects that theIslamic market is characterized by a moderate concentration.

Having analyzed the ratios of concentration as first traditional measure of thestructure of market, the analysis of the second measure which is Hirschmann-Herfindahlindex show that the values of three indicators HHI calculated for both markets are lessthan 1,000. It implies that these two markets are weakly concentrated according to theAl-Muharrami et al. (2006) and Gajurel (2010) results for the conventional banks.

The calculation indicates that the Islamic market register values of HHI higher thanthose obtained for the conventional market describing a more intense concentration.Table V also shows a certain stability of the values calculated for the sample of theconventional banks, reflecting the stability of the competitive structure of this bankingmarket. As for the Islamic market, the decrease of the values of HHI shows theexpansion of the Islamic banking sector and the increase of the number of its financialinstitutions. The results of the HHI confirm what we obtained by interpreting theratios of concentration C3 and C5. We can say that the Islamic banking industry ismoderately concentrated than the conventional industry. It justifies that this newindustry is in a phase of development and it has not reached the stage of a competitionequal to that of the conventional banking sector.

HHI total assets HHI total deposits HHI total loansYear Islam. M Conv. M Islam. M Conv. M Islam. M Conv. M

2004 866 248 830 259 1,002 2832005 771 239 679 244 864 2652006 703 229 613 231 718 2562007 639 221 613 219 673 2442008 641 222 624 222 682 2292009 597 282 541 294 668 283Average 703 240 652 244 768 260

Table V.The HHI index of the totalasset, total deposits andtotal loans

C5 total assets C5 deposits C5 loansYear Islam. M Conv. M Islam. M Conv. M Islam. M Conv. M

2004 0.5981 0.2383 0.5585 0.2413 0.6371 0.28622005 0.5646 0.2323 0.5099 0.2328 0.5808 0.25992006 0.5333 0.2193 0.4918 0.2231 0.5506 0.24802007 0.5043 0.2072 0.4909 0.1993 0.5286 0.23092008 0.5102 0.2077 0.5023 0.2022 0.5315 0.21062009 0.4846 0.2526 0.4535 0.2591 0.5128 0.2435Average 0.5325 0.2262 0.5012 0.2263 0.5569 0.2465

Table IV.The ratios ofconcentration C5according to the totalasset, total deposits andtotal loans

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4.2 New indicators of competition and market powerWe propose to calculate the PR-H, which is refers the degre of competition. In firststage, we calculate the H-statistic for all the period studied for both markets as well astest of equilibrium. Then we calculate it for every year of the period of study for bothmarket, this operation allows us to take into account the changes relative to thetechnological progress.

Table VI presents the test of equilibrium of the statistics of Panzar and Rosse(1987). The statistics for both markets is very close to zero and not significant.We note that Shaffer (2004) underlines that the rejection of the test of equilibriumdoes not distort the inferences based on the results of the estimation of this indicator.He argues that the hypothesis of the long-term equilibrium is not strictly necessary inthe presence of the positive values of the statistics (the values obtained at the level ofour study are quite positive during the global estimation as well as during the annualestimations). He also underlines that the no equilibrium can suggest a dynamicdevelopment of the industry.

According to Table VII relative to the calculation of the PR-H, the statisticscalculated for both samples belongs to the interval [0-1]. We note that the value of thePR-H statistics of the Islamic panel is weaker than the conventional sample,respectively, equal to 24.81 percent and 55.91 percent. The Islamic market is moremonopolistic. We can thus assert that both markets are in a situation of monopolisticcompetition, it means that an increase in input costs will lead to a less proportionalincrease of revenues.

The annual calculation of the statistics PR-H for the analysis of the competitiveconditions allows us to take into account the effect of the technological changes on thestructure of market. The estimation of equation (2) relative to the test of equilibriumgives the results illustrated by Table VIII.

We observe that all the values found for both markets are very close to zero whatimplies that both segments of banking market are not in long-term equilibrium.According to the interpretation of Shaffer (2004), we can neglect the hypothesis oflong-term balance when the values of PR-H are positive (Table IX).

V. dependant Ln (1 þ ROA)V. independant Islam. M Conv. M

Ln (WL) 0.0059 20.0016(0.0028) * * (20.81)

Ln(WF) 20.0017 20.0028(0.0018) (21.44)

Ln(WK) 0.00077 20.0028(0.0014) (21.16)

Ln(Y1) 20.0001 0.0077(0.003) (1.48) * * *

Ln(Y2) 20.0036 0.0061(0.003) (1.73) *

Cons 0.0377 0.0104(0.014) * * * (0.67)

E-statistic 0.058 20.0072

Notes: Significant at: *10, * *5 and * * *1 percent; the estimation is based on a model with fixed effects

Table VI.Result of the equilibrium

test


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For the conventional market, the values vary from 54.98 to 66.22 percent with an averageequal to 63.73 percent. This market is characterized by a monopolistic competition.For the Islamic market and with the exception of the value registered for the first year,we can say that the market exhibit a situation of monopolistic competition. We observean increase of PR-H in 2006 and in 2007 then a decrease in 2008 and 2009. These resultsconverge with what we found during the global estimation of the statistics and confirmthe situation of monopolistic competition as the competitive situation for each of themarkets with more concentration in the Islamic banking.

V.dependant Ln TR: total log revenuV.independant Islam. M Conv. M

Ln WL 20.5486 0.1299(0.07) * * * (1.34) * * *

LnWF 0.1821 0.3068(0.044) * * * (8.17) * * *

LnWK 0.616 0.1223(0.34) * * * (3.35) * * *

LnY1 20.0438 0.0992(0.0645) (2.02) * * *

LnY2 0.495 0.2600(0.072) * * * (2.40) * * *

Cons 0.3084 0.0184(0.339) (0.04)

PR-H 0.2481 0.5591

Notes: Significant at: *10, * *5 and * * *1 percent; the estimation is based on a model with fixed effects

Table VII.Calculation of PR-Hstatistic

Year Islam. M Conv. M

2004 0.00341 20.005142005 0.00627 20.007052006 0.01057 20.010662007 0.00278 20.003772008 0.00356 20.003772009 20.00297 20.00382

Table VIII.Results of the test ofequilibrium


2004 0.0512 0.66222005 0.2194 0.60642006 0.3858 0.54982007 0.4903 0.60682008 0.2944 0.64222009 0.2207 0.7568Average 0.2770 0.6373

Table IX.Annual values of PR-Hstatistics

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Our results are on-line with those found by previous studies such as Vesala (1995),Murjan and Ruza (2002), Abdul Majid and Sufian (2007), Khan (2009) and Gajurel (2010)for the conventional banks and specially those Turk Ariss (2010) for Islamic banks. Theresults suggest that the monopolistic competition describes better the competitivesituation of both Islamic and conventional markets. However, the PR-H statistics ofthe conventional market is higher than that of the Islamic banking market; this resultdiverges with the result of Turk Ariss (2010) and Weill (2010). This can encourage Islamicbanks to develop and to diversify their products in order to increase their differentiation.

In the end, we propose to calculate the Lerner index, which is refers to the degree ofmarket power. The Lerner index measures the capacity of a bank to increase its pricewith regard to its marginal cost. The coefficients obtained from the estimation of thefunction of cost presented by equation (3) allow us to calculate the marginal cost of thebank illustrated by equation (4). The passage by these two stages is necessary tocalculate the Lerner index which is the distance between the price and the marginalcost (equation (5)).

Table X presents the annual averages of the Lerner index calculated for every typeof bank. The average index of the Islamic market for all the period is 94.39 percent.The values vary between 93.71 and 95 percent. We observe that the Islamic banksregister a high values and have a great market power which can influence the pricesof products and services offered. This can be explained by the demand of Islamicproducts which is upper to the supply. Also, Islamic banks use Sharia compliantproducts and interest a specific segment of customers. For the conventional bank,average is equal to 31.23 percent and annual values vary between 29.07 and37 percent. It appears that the conventional banking institutions have less marketpower than the Islamic banks. The degree of market power registers a little decreasebetween 2006 and 2008 perhaps due to financial crisis that reduce the margin andincrease the loss of some banks.

5. ConclusionIn this article we examined the competitive conditions and the market power of Islamicand conventional banks. We apply two approaches related to the traditional and thenew industrial organization literature through HHI index, the Panzar and Rosse modeland the Lerner index. The statistics show the remarkable increase in size of Islamicbanks between 2000 and 2009, despite they remain less than those of conventionalbanks but the Islamic banks are better capitalized. In terms of profitability, there is nosignificant difference between both types of banks. Although they are less capitalized,the equity of the conventional banks generates more profit than those of the Islamic


2004 0.9500 0.30052005 0.9460 0.32532006 0.9371 0.29072007 0.9378 0.29532008 0.9443 0.29212009 0.9485 0.3700Average 0.9439 0.3123

Table X.The Lerner index


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banks, perhaps due to the leverage effect. These statistics can explain that Islamicbanks are less competitive than the conventional banks.

According to ratios of concentration, conventional market exhibits a highfragmentation or weak concentration. The Islamic market is characterized by amoderate concentration; however the values indicate that the concentration of Islamicmarket has been declining since the year 2004. This leads to conclude that the Islamicmarket knows an important expansion due to the entry of new banks on the market. Thecalculation indicates that the Islamic market register values of HHI higher than thoseobtained for the conventional market but both segments exhibit low concentration.A certain stability of the values calculated for the sample of the conventional banksreflects the stability of the competitive structure of this segment. For the Islamic market,the decrease of the values of the HHI below 1,000 since the year 2004 shows theexpansion of the Islamic banking industry. It means that Islamic banking sector falls inthe range of a competitive market structure.

According to our hypothesis of the beginning, the various tests of PR-H statisticsuggest that both sectors are consistent with a monopolistic competition marketstructure. The global Islamic banking market exhibits less competition compared tothe conventional banking. The Islamic banks have a degree of market power muchhigher than the conventional banks. In some cases, it is necessary to note that theIslamic banks shows an oligopolistic tendency, it justifies that this new industry is in aphase of development and it has not reached a stage of a competition equal to theconventional banking. In this context, and with the multiplication of the Islamic banksin the MENA and Southeast Asia, the enhancement of Islamic bank competitiveness byoffering new products is determinant for their success.

Our research focuses exclusively on the countries where the data are available andexcludes the other countries where competition and market power might have differentforms. For future research, it is requested to examine the impact of market power onrisk-taking behavior. In fact, it is important to test if banks with higher market powertake more risk or not and if with decreased market power banks reduce their riskybehaviors or not. According to Boyd and Nicol (2005), a bank can assume more risktaking if there is an increase in its market power. This can be explained by the fact thatgreater market power allows the bank to charge higher loan rates and increase theirrents in the loan markets. An increased knowledge of the relationships among bankmarket power, the capitalization of banks and banks risk-taking behavior can improvethe effectiveness of governmental regulation and the financial stability (Tabak et al.,2012).

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Corresponding authorHichem Hamza can be contacted at: [email protected]

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Competitive conditions and market power of Islamic and conventional commercial banks