Finance Exam Prep Task
B1. What is the best method to measure competition in banking markets? Within your discussion consider at least two different approaches used to measure competition in banking markets within the academic literature and critically discuss their relative benefits and failings.
Banking is the system that controls the supply and demand of money in a country. Banking system plays the important role of protecting the Wealth of people. The banking system also helps the people settle their needs by lending the reserved money to the people where the demand exceeds the supply. Banks are there to create extra money to use while residing in the same country by creating fake money in the form of loans. Fake Money is not fake rather it is an illustration of the multiplier effect of money. Due to these certain attributes, banks are considered as a vital part of a country’s financial cycle. In the present time with the advancement of Globalization, the competition and hence the importance of banking system has increased than ever before. Banking competition has been the subject of many studies since the great financial crises. Stability in the banking system has the impact on the economy of the country. Ambiguity in the determination of competition in the banking sector has resulted in the generation of many approaches to measure it. There are many methods of measuring the competition in the banking sector and hence the consequences of this competition on the economy of the country. There are two basic approaches of measuring the competition in the banking sector. These approaches have their specialities and drawbacks in determining the competition.
Structural Approach of Determining the Competition in Banking Sector:
The structure of components which shape the banking system of a country has an important role in determining the competition of banking sector. The structure of components can be described as the size and quantity of firms that constitute the market in which banks operate. Structure-Conduct-Performance was first described by Mason and Bain (Cseres, 2005). Mason and Bain were the two economists who described the performance of the firms on the basis of structural parameters of the market. This approach describes that with the increase in the number of firms there are greater possibilities of collision among the firms and hence with the large firms the prices are less likely to change which is non-competitive behaviour. The concentration of the market that is the structural parameter is considered to be the most applicable way of describing the competition in the market but with the time many variations came into existence. It was proposed that the market structure is irrelevant in determining the competition. The competition in a market was determined by the conditions under which the firms can enter or exit the market. Lower conditions of entry and exit from the market were faced with the higher number of entry or exit threats which showed that the number of firms and their sizes were not declaring the competition in the market (González-Díaz & Snelders, 2013) . Rather there were some un-structural parameters that were the real determinants of competition in a market.
Specifications and Short Comings of SCP:
Among the many advantages of the structural approach of defining the competition in the market, the most important was the simplicity. As this approach was more useful and compatible due to the way it determines the competition. This approach doesn’t require much of market data and hence it can be used by the growing economies of the world. With the simplicity, this approach was low on the precision scale and hence it was faced with many practical and conceptual limitations. According to the modern theories there comes to be no relation between the concentration and the competition in the market (Pitelis & Sugden, 2005). For instance, the banks that reside in the local market have to face the non-financial competitors that make the financial structure of the market more complex and the structure of that local market irrelevant to the competition.
Non-Structural (Empirical) Approach of Determining the Competition in the market:
Due to uncertainty in the structural approach of determining competition in a market, many direct methods were devised in determining the competition. Under the direct non-structural approach, the competition can be determined by directly observing the behaviour of firms in a market. According to this approach, every single firm is not passive in any aspect rather the firms can make diverse decisions and the strategies. These decisions by the firms are interdependent and interrelated, as the decision of one firm has an impact on the other firms of the market. Thus for analyzing the competition in the market, the analysts have to determine the behaviour of firms in response to the supply and demand of the goods in the market. As the supply and the demand of goods would determine the equilibrium in the market, and ultimately this inertia would intrigue the firms to behave accordingly (Polanyi, 2001). Thus, the empirical approach of describing the competition in a market was related to the conduct of firm that was the result of certain supply and demand parameters. As the firms always respond and behave in accord with the demands and supplies of a market.
Specifications and Short Comings of Empirical Approach:
An empirical approach is simpler than the others in defining the market competition. As this approach deals with the conduct of the firms in order to determine the competition in the market.
Determining the behaviour of firms in a market is a direct and more precise way of judging the competition in the market. Furthermore due to this direct study, more efficient possibilities would develop for the uplift of an economy. As with the empirical approach, the analysts would be able to study the evolution of bank pricing behaviour over the period of time. Hence knowing the banking system very closely would help the analysts in finding the loopholes of the system. But to the bad of this un-structural study, it is not easy rather feasible in most of the complex market structures, to conduct an un-structural study of the market. As most of the markets are more complex, having the mixture of many foreign and non-financial institutions.
B2. The US banking system has experienced rapid consolidation over the last 20 years driven by market power, scale economy and Too-Big-To-Fail motives. Please analyse the impacts of bank mergers and acquisitions on US bank risk-taking behaviour.
There are many reasons of change in the banking system of a country. Such reasons intrigued the change in US banking system. The banking system of not only United States but also of the whole world has been transformed in the recent past. The reasons for such transform count the globalization of modern world in which all the countries are inter-dependent and inter-connected than ever before. Countries in the present world are also financially connected making the whole economic system of the world more complex. Furthermore due to the privatization of public and government owned banks and further the advancements in the ways of doing business the banking system has been brought to great change than the past (Green, 2008). Apart from this, globalization has brought the countries closer than before due to which a local bank has now to face competition from the foreign financial firms. Rather not only the financial firm but also many non-financial institutions have also joined the race of the corporate world. Furthermore due to the usage of many electronic financial instruments (Like that of Debit and Credit cards, electronic funds transfers) banking systems has become very different as compared to traditional banking. The factors that affected the US banking system and resulted from the banking mergers over the near past have been counted below:
Behaviour of Corporate World:
Due to advancement in the modern technology the banking system of US like the rest of the world has been affected in both direct and indirect way. The direct effect of technology on the banking system can be realized by the usage of many applications that define the financial risks and the marketing of various products. Apart from the direct effect, advancement in the technology has also affected the banking world in an indirect way. Like the change of corporate behaviour and the development of financial markets. This indirect impact can be clearly felt in the case of technology firms, which are more often forced to go for capital markets in order to finance their projects. As most of the banks are not in the favour of accepting uncertainty associated with the development of technology firms.
Relation with the Corporate Customers:
Another ramification of the developments in the banking system is that the commercial banks in bank-oriented financial systems are unable to maintain their traditional close relationships with their customers. Because of the pressure from alternative financing sources which can be both domestic and foreign banks, there has been an increase in the emphasis on the value of shareholders which are now considered to be only commercial objective of banks. Banks in most of the growing countries like that of Germany and Japan, financial systems are more related with the shareholder relations rather than the traditional corporate customers. As they seem to maximize their profits and returns. The new relationship between the banks and the corporate customers has brought various changes in the banking system which may include the bank mergers.
The history is well recognized with the bank crises. During the 1990s, due to the massive banks failures the external and internal banking systems were deregulated (International Monetary Fund, 2006). Despite all the attention given to the complex derivative products that resulted in the high-profile collapses of some corporate banks, most of the banking system was collapsed due to the poor management of loans. The proportion of loans that later became impaired and resulted in the banking crises has been much greater than that in the whole industrial world.
Due to the change of various market affecting parameters, the banking system has been changed over the period of last 20 years and hence resulted in massive mergers. The banking systems of many growing economies of the world have been distributed on the basis of number and size, profitability and ownership and also the use of various technological instruments. Moreover, it has been seen that there are more than three or four large commercial banks that coexist with a large of smaller banks which are either rural or urban. In general, certain small commercial banks, even larger ones, are also listed on the stock exchange to exist and compete in a market. Profitability is a parameter that varies widely, as in the case of some banks which are earning greater returns but operating very inefficiently. Furthermore, there are some other types of banks which compete only for a small segment of the market.
Some of the commercial banks in the developed countries are at the critical edge of technology while many banks are still trying to master the financial fundamental such as credit risk assessment and liquidity management. But with the financial crisis the banking system became more weaken than before and left the firms with the only option of merger and sustain in the crisis. The merger was the only option for most of larger and smaller banks in the time of crisis. As every bank was in need of the other and not even a single bank was capable of maintaining itself in the market without any merger. Thus considering the merger as the only vehicle of improving the efficiency of financial markets, many giant entities went through the consolidation process.
Evidences have been showed that the mergers have also impacted the competition in the market as the market was left with the smaller number of individuals; thus, the competition among the firms was reduced than before.
Apart from the competition the mergers have also changed the behaviour of many corporate entities, like the risk taking behaviour of banks. After the mergers, the banks were more oriented to the stability and existence rather than the profitability. This was the reason why these banks showed the risk averse behaviour after the economic crisis.
C2. Testing the Capital Asset Pricing Model and multifactor models of asset pricing.
How would you calculate the average returns predicted by the CAPM on the graph?
In order to calculate the average return that is predicted by the graph, we would need the three components of CAPM. The required components of CAPM, includes risk free rate of return, market risk premium and the beta. We can determine these components from the graph, like the y-intercept of SML line is the risk free rate of return, the slope of SML is the market risk premium, and the beta is given for particular stock. Beta is calculated from the past data of the stock. Beta is the factor which incorporates the risk in determining the asset return.
The formula of CAPM which is used to measure the asset return is:
Required Return= Risk free rate of Return + Beta *Market risk premium
Required Return= 0.72
Explain the implications of the above graph for the CAPM and the Fama-French Factor model.
Capital asset pricing model (CAPM ) is used to determine the expected return of a portfolio by incorporating the effect of risk on the return. This method is used by most of the investors, in order to find the most optimal stocks to invest in. Like the one that has the highest possible expected return and the lowest possible risk linked to it. When the annualized return is plotted against the relative betas, the line formed is called as Security market line (SML). SML defines the expected return of the stock as the function of systematic risk which is also known as non-diversifiable risk. Thus, the above graph shows the relation of expected return with the various betas. In the graph, the stocks that are placed over the SML are considered to be correctly valued. While the stocks which are above the security market line are considered to be undervalued and hence these stock are favourable for the investors. Due to the market reaction, undervalued stocks are moved towards the SML in order to get correctly valued. This behaviour shows the typical equilibrium state of the market which is achieved by every stock after sometime. Apart from this, the stocks which are under SML are considered as overvalued and hence most of the investors are inclined to discard them. This behaviour again brings the stocks to the SML, where they are declared to be correctly valued.
In order to determine the annualized return by using CAPM, we would require the market return, risk free rate of return and the beta (factor describing the change in the return of specific stock with the change in return of the market). The Y intercept of the SML is defined to be the risk free rate of return while the slope of SML reflects the market risk premium. All these variables are gathered by the simple formula for computing the expected return. A market factor that is called Beta is determined from the past data of the stock by finding the relation between the return of stock and that of the market.
Contrary to CAPM, which uses only one variable in determining the expected return of a stock, Fama-french factor model uses three of variables to calculate that expected return of the stock. Fama-french model is considered superior to CAPM, due to greater flexibility and compatibility in determining the expected return. This model uses Beta, value and size of the stocks to determine their expected returns. As per the above graph, the Fama-French model states that the stocks that have the smaller cap and have the lowest B/M ratio are expected to perform more than the market.
Critically discuss whether the CAPM is dead.
Capital Asset Pricing Model (CAPM) is the traditional model which is used to determine the relation between the expected return and the risk. As per CAPM, the expected return or the return of the specific portfolio can be measured by using only one variable which is beta. CAPM is simpler than the other methods and due to its small requirements it is easy to use as well. The investors have to weigh the return which they would receive for taking a certain risk. CAPM is the method which helps the analysts in determining the return of the portfolio while incorporating the risk. CAPM also determines the time value of money which is an important factor in the calculation of return. The value of money decreases with the time; hence the investors must also be compensated for the time they are investing their money. CAPM is used by most of the present day analysts due to its simplicity and compatibility. Even after the derivation of many advanced methods of asset pricing, CAPM has maintained its importance. Since 1973, no one questioned the feasibility of CAPM, but the new empirical theory by Fama and French brought trouble for CAPM. As its authenticity was under question, the new theories were departing from CAPM by declaring different factors of calculating the expected return of the portfolios. According to the new empirical theories, the return to an asset should be determined by its Price of earning ratios or market to book ratios which are contrary to CAPM. As CAPM declares that the return of an asset is only determined by its beta, not by P/E or M/B ratio. It was also proved from the research that the asset’s return in determined by its size, value and the beta. These researches were contrary to the fact that return could only be found by using the beta. Fama-french factor model which is considered more advanced than the CAPM is also criticized by some of the researches, as it considers the unnecessary parameters in determining the asset return. So it can be declared that CAPM is not dead, rather it is more explored in the latest theories. CAPM can be described as the base of modern empirical theories describing the asset valuation. It can’t be set as black and white by declaring some approaches as the right and the others as wrong. The difference is that the modern theories provide more explored view of asset pricing mechanism than the CAPM, but this doesn’t mean CAPM is dead.
Cseres, K. J. (2005). Competition Law and Consumer Protection. Kluwer Law International.
González-Díaz, F. E., & Snelders, R. (2013). Abuse of Dominance Under Article 102 TFEU. Claeys & Casteels.
Green, D. (2008). From Poverty to Power: How Active Citizens and Effective States Can Change the World. Oxfam.
International Monetary Fund. (2006). Australia: Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the following topics: Banking Supervision, Insurance Regulation, Securities Regulation, and Payment Systems. International Monetary Fund.
Pitelis, C., & Sugden, R. (2005). The Nature of the Transnational Firm. Routledge.
Polanyi, K. (2001). The Great Transformation: The Political and Economic Origins of Our Time. Beacon Press.