The Evaluation of the Relationship between Cost Efficiency and Competition in Iran’s Banking Industry

One of the main goals of all countries is economic growth. This purpose can be accessible through having strong financial sector that provides finance for real sector. One of the main problems of the Iranian economy is the high share of the banking sector in financing economic activities. According to the evidence of statistical center of Iran, the share of the banking sector to finance economic activities is over 90 percent. Therefore, considering the importance of banking sector in economy, studying bank performance is very important. One of the criteria for banking performance is cost efficiency. Higher cost efficiency leads to an increase in the flexibility of banking sector to negative shocks. In the last year, the number of banks in Iran has increased; therefore, competition between banks will increase to gain higher share of the market. The banks' reactions to the increase competition cause changes in the financial structure of banks. This study tries to investigate if competition can have any effect on cost efficiency.

Theoretical literature on the relationship between competition and bank efficiency can be explained as follows. The Quiet Life Hypothesis (QLH) was first suggested by Hicks (1935). Based on QLH, market power allows firms to enjoy a quiet life, but such a life reduces firm managers’ effort to maximize their firm efficiency. In other words, managers can exercise market power of banks to gain supernormal profit without making efforts to work or control costs toward increasing bank efficiency. Thus, increased monopoly power results in a decrease in efficiency whereas competition fosters bank efficiency.
Demsetz (1973) in his Efficient-Structure Hypothesis (ESH) suggests that an efficient firm can lower costs of production and thus gain both higher profits and larger market shares. Thus, as the market becomes more concentrated and banks can exploit greater market power, they face less competition. As a result, the ESH posits a positive causality running from efficiency to market power.
The Information Generation Hypothesis (IGH) theorizes a negative relationship between competition and efficiency. IGH is based on the view that banks are special intermediaries because they have access to borrowers’ information to collect and analyze internal/personal information. Thus, they are able to reduce their adverse borrower selection to a minimum level due to the ability to generate superior information compared to their peers (Koetter, Kolari & Spierdijk, 2008). To summarize, competition among banks leads to a decline in their information-gathering capacities, and eventually results in a higher probability of adverse borrower selection and thus higher bank inefficiency.

In this study, parametric Stochastic Frontier Approach (SFA) is used to measure the cost efficiency of 18 Iranian commercial banks. The SFA is a stochastic method because it allows banks to be distant both from the frontier and randomness. It differs from Data Envelopment Analysis (DEA) which supposes that to be far from the frontier is entirely due to inefficiency. We then use these measures to examine whether bank competition enhances or impedes bank cost efficiency by employing generalized method of moment approach.

The results of cost inefficiency show that, the entire mean cost inefficiency of 18 Iranian commercial banks is 0.146 in 2006 and increases over the sample period to 0.265 in 2014. The cost inefficiency of Melli banks is the highest while that of Sina bank is the lowest. Cost inefficiency of privately-owned banks are relatively higher than stat-owned banks. The results of Granger-Causality indicated that there is bidirectional causality between competition and cost efficiency. Also, the results of GMM estimation show that higher inflation, low growth rate and higher competition have positive effect on cost inefficiency. Therefore, information generation hypothesis in Iran banking industry is verified because increasing competition leads to a decline in their information-gathering capacities, and eventually results in a higher probability of adverse borrower selection and thus higher bank inefficiency. These effects have been proved for loan and deposit market.
The results of factors affecting competition indicated that increasing inflation, growth rate, size of the banks and cost inefficiency have positive effect on competition. Therefore, the efficient-structure hypothesis can be confirmed, and higher cost inefficiency leads to increasing in competition.

One of main goals of this study is to find out the relationship between competition and cost inefficiency in banking industry over 2006-2014. The results of study show that macro-level variable is the most important in determining cost inefficiency. Therefore, creating economic stability and increasing economic growth can lead to an increase in cost efficiency. Moreover, the Central Bank’s supervision should increase over commercial banks and controlling entry of new banks for increasing the quality of banking system and increasing the quality of borrowers by strong screening process.