Financial Liberalization and Competition in Banking: An Empirical Investigation

We find that Israeli banks lost market power following financial liberalization, despite the fact that the banking industry remained highly concentrated. Building on methods developed by Bresnahan (1982) and Porter (1983), we estimate "monopoly power" and "monopsony power" conduct parameters for the non-indexed local currency loan and deposit markets. In both markets, the hypothesis of perfect competition is rejected, but the market for bank loans is less competitive than the market for bank deposits. We allow the conduct parameters to vary over time, finding a large and statistically significant increase in competition in both markets. We further find that the estimated coefficient of the Euro interest rate in the demand schedule for loans is significantly larger in the second half of the sample period. These findings suggest that international financial liberalization is responsible, at least in part, for the rise in bank competition. A similar process of financial liberalization is taking place in many European countries, and the recent abolition of restrictions on interstate banking in the US is conceptually similar to financial liberalization. The Israeli case can serve as a laboratory for studying the effect of financial liberalization on the competitive conduct of banks.