China Finance Review International

The influence of the market power of Chinese commercial banks on efficiency and
stability
Xiangning Wang Xianming Zeng Zhiyang Zhang
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Chinese
The influence of the market commercial banks
power of Chinese commercial on efficiency and
stability
banks on efficiency and stability
Xiangning Wang and Xianming Zeng 307
Department of Statistics and Finance, The School of Management,
Received 18 July 2013
University of Science and Technology of China, Hefei, China, and Revised 15 November 2013
Zhiyang Zhang 26 December 2013
Accepted 24 February 2014
Shenzhen Marketing Centre, Guosen Securities Company Limited,
Shenzhen, China
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Abstract
Purpose – The purpose of this paper is to estimate the cost and profit efficiency (PE) of Chinese
commercial banks in the last ten years and investigate how market power affects bank efficiency
and stability.
Design/methodology/approach – The paper builds a stochastic frontier analysis model to evaluate
the cost and PE of commercial banks. The paper then uses a Lerner index and Z-index to represent
market power and stability, respectively. In addition, the paper empirically analyzes the relationship
between market power and bank efficiency, stability in the last ten years.
Findings – The results show that the efficiency of banks on the Chinese mainland increased during
the study period, but is still lower than that of banks in Hong Kong; moreover, the efficiency of four
state-owned commercial banks is lower than that of medium and small banks. Market power has a
negative relationship with efficiency while its relationship with stability varies among Chinese banks.
Research limitations/implications – The results imply that the promotion of financial
liberalization and banking reform to introduce an appropriate competition mechanism has had a
positive effect on the efficiency and stability of Chinese commercial banks.
Practical implications – Thus, the paper will contribute to deepen reform and opening up the
banking sector in China.
Social implications – The healthy development of banking can enhance the ability of banks to
withstand financial risks, to promote the harmonious development of society.
Originality/value – The paper estimates the cost and PE of Chinese commercial banks using SFA
model and investigates how market power affects bank efficiency and stability. The study design
has a certain novelty, where Lerner index and Z index are used, respectively, to measure market power
and stability and management efficiency of commercial banks is investigated from two aspects –
PE and cost efficiency – by the translog cost function, instead of Douglas production function.
In addition, the paper tries to put some of Hong Kong banks included in the study sample, and has a
certain reference value.
Keywords Stability, Efficiency, Market power, Commercial banks, Stochastic frontier model
Paper type Research paper

Financial liberalization has increased since China entered the WTO in 2001. Banking
deregulation has allowed domestic commercial banks broader space for development
and foreign banks have been able to enter the market. This has increased cooperation

China Finance Review International

JEL Classifications — D40, E43, G21, L10 Vol. 4 No. 4, 2014
The authors would like to thank anonymous referees for their valuable comments and pp. 307-325
r Emerald Group Publishing Limited
suggestions. The authors also thank International Science Editing for their excellent English 2044-1398
editing. Any mistakes in this paper are the authors’ responsibility. DOI 10.1108/CFRI-07-2013-0096
 CFRI opportunities between domestic and foreign banks. This structural reform of the
4,4 banking sector has led to sustained increases in banking service levels and competitive
power. Statistical data for 2009 from the China Securities Regulatory Commission
show that the total net profit for the Chinese banking sector was more than 500 billion
Yuan, which is an increase of 30.6 percent compared with 2008 and is among the
best in the banking world in terms of total profit, profit growth and return on
308 capital investment.
However, financial liberalization also means that banks face greater risks that could
lead to weakness and volatility, especially after December 2006, when domestic
banking was fully opened to foreign banks, and the disadvantages of domestic banks,
such as a low ability to innovate, to supply services and to price, became obvious. The
two financial crises in the late 1990s and 2008 warned that banking stability is the key
to financial stability. Thus, a question worth considering is how Chinese banking can
survive and develop in the face of intense competition from foreign banks in terms of
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advanced management technology and highly efficient services.

It should be noted that, for the commercial banks, market power, operations
efficiency and stability are not only complementary, but also sometimes restrain each
other. This paper investigates the relationships among market power, management
efficiency and bank stability for Chinese commercial banks, comparing with
management efficiency of banks in Hong Kong. The surveyed banks include 21
commercial banks on the Chinese mainland and 11 commercial banks in Hong Kong. In
addition, Lerner index and Z index are used, respectively, to measure market power
and stability. Management efficiency of commercial banks is investigated from two
aspects – profit efficiency (PE) and cost efficiency (CE) – by the translog cost function,
instead of Douglas production function. Finally, our study shows that market power
has a negative relationship with efficiency, while its relationship with stability varies
among Chinese banks. Moreover, the overall efficiency of Chinese commercial banks is
increasing, but yet much lower than that of banks in Hong Kong.
The rest of the paper is organized as follows. Section 2 reviews the literature on
these issues. The status and background of market power of China’s commercial banks
are discussed in Section 3. Section 4 introduces the theoretical model and variables.
Section 5 presents our data and the empirical analysis method. Section 6 gives the
estimation results and concluding remarks are given in Section 7.

1. Literature review
Market power
Market power, also known as monopoly power, is the capability possessed by
companies to price above the marginal or incremental cost in an imperfect competition
market. This concept also applies to banking because it is an industry with high
administrative intervention. The credit market, which is dominated by commercial
banks, is also an imperfect competitive market, so there must be a certain degree
of market power. From the endogenous factors point of view, this type of market
power arises from the spread between bank deposit and loan interest rates, exchange
fees, the number and coverage of bank outlets, the safety of bank management, the
yield of various financial products and the efficiency of other services.
In essence, market power is the capability of economic entities to control the market
price, which means that the corporation is more competitive and has higher corporate
value. Thus, market power is typically used to measure the degree of monopoly of a
corporation. For a bank, the greater its market power, the more obvious is its monopoly
 position and the less competition it faces, so it will be easier to obtain huge profits. Chinese
Market power leads to high profits, but does this necessarily mean that the bank has commercial banks
greater efficiency and better profit stability? There is no academic consensus
on the relationship between market power and efficiency, or on whether the on efficiency and
competition-stable or competition-fragile theory is more consistent with the facts. stability
Market power and bank efficiency 309
For a bank, operating efficiency can be divided into CE and PE (Leibenstein, 1966).
Over the long term, competition and efficiency are inseparable. Demsetz (1973)
proposes an efficiency structure hypothesis, according to which the most efficient
banks can survive competition and inefficient banks are eliminated, so banks with
greater market power tend to be more efficient. Casu and Girardone (2006) use
non-parametric data envelopment analysis (DEA) to estimate the efficiency of the
banking industry within the EU and apply the Panzar and Rosse (1987) approach to
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calculate market power; their results show no clear relationship between efficiency
and market power. This may be because the Panzar-Rosse approach measures the
long-term competition status of the industry, and is not suitable for estimating
the relationship between competition and efficiency for each individual bank. Thus, in
recent years researchers have used the Lerner index (Lerner, 1934) to measure market
power at a single bank level. Maudos and de Guevara (2007) use the Lerner index to
measure market power and find a significant positive relationship between market
power and CE for banks in Europe. Schaeck and Čihak (2008) use banking data from
the USA and Europe and conclude that the market power a bank gains from
competition enhances its PE. Koetter et al. (2008) admit that competition and efficiency
are mutually intertwined. To avoid endogeneity in the estimation process, they use
a Lerner index adjusted for effectiveness for the first time, and estimation methods
such as two-stage least squares and instrumental variables to study the market power
of American banks. Their results fully support the efficient structure hypothesis.
However, not all studies support the efficient structure hypothesis. Berger and Hannan
(1998) use the US banking industry as evidence and find that efficiency is significantly
lower for banks that lack competition pressure than for banks that grow up under
competition, because when a bank has market power, it is easy to obtain huge profits
and thus it has no incentive to reduce costs. Delis and Tsionas (2009) use samples
from US and European banks and introduce a new maximum positioning technology
to estimate the market power of banks. They establish an empirical framework that
can jointly estimate efficiency and market power and find a negative relationship
between efficiency and market power. All of these studies focussed on the banking
industry in developed countries. Using data for 821 banks in 60 developing countries
in Africa, Eastern Europe, Latin America, the Middle East and Asia apart from China,
and an efficiency adjusted-Lerner index as a measure, Turk-Ariss (2010) finds
a negative relationship between market power and CE and a positive relationship
between market power and PE in developing countries.

Market power and bank stability

The traditional competition-fragile theory argues that competition between banks
increases instability in the banking credit system and the probability of operational
risk. Therefore, although market power causes a certain efficiency loss, academics
accept that it is necessary at a certain level. Keeley (1990) suggests that excessive
competition encourages banks to raise deposit interest rates and lower lending rates
 CFRI and thresholds, which reduces a bank’s profit margins and increases the likelihood of
4,4 moral hazard; thus, banks have to bear more risk, which is an important reason for the
sharp increase in bank bankruptcy in America in the 1980s. Hellmann et al. (2000)
study the cause of the banking deposits and loans crisis. They use banks in the USA
and Japan that bore too much risk as an example to illustrate the point that financial
liberalization of the banking industry reduces entry barriers, limitations in setting up
310 branches and the regulation of interest rates, but increases competition, which causes
banking instability. Instead, Petersen and Rajan (1995) suggest that if a bank has
market power, it can avoid the problem of information asymmetry to a great extent,
can develop sustainable corporate relationships with enterprises and can effectively
assess the repayment ability of borrowers and thus benefit from improvements in loan
quality and enhanced operating stability. Meanwhile, as the bank faces great
bankruptcy costs, it will be more careful with risky business, and will tend to hold
more equity capital and less risky portfolios. Jiménez et al. (2007) use the Lerner index
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as a measure of market power and find a negative relationship between market power
and risk in the Spanish banking industry, so they argue that bank stability increases
with market power. Berger et al. (2009) point out that in developed countries, a bank
with high market power will use risk reduction techniques such as an increase in
equity capital to reduce risks or increase stability. Using data for 23 banks in developed
countries and the generalized method of moments, the authors prove that market
power can help banks to avoid overall risk effectively.
However, recent literature provides both theoretical and empirical support for the
competition-stable theory, which argues that banks may face more risks when they
have market power. In other words, bank stability will increase with the level of
competition. For example, studies by Stiglitz and Weiss (1981) and Boyd and De Nicolo
(2005) indicate that banks with market power can charge a higher interest rate for
commercial loans to gain more income. However, a higher interest rate increases the
cost for borrowers. On the one hand, this induces borrowers to invest in projects with
higher risks (Stiglitz and Weiss, 1981), and on the other hand it increases the
probability of adverse selection and moral hazard, which would increase the risk level
of the bank’s client base and its non-performing loan ratio, and would thus influence
bank stability (Boyd and De Nicolo, 2005). Caminal and Matutes (2002) argue that
because monopoly banks face high regulatory costs, they are more prone to hold
high-risk loan assets, which decreases bank stability. Uhde and Heimeshoff (2009)
use samples from the US and Japanese banking industries to verify the
competition-stability theory empirically. Their results show that the probability of
bankruptcy increases with the level of concentration in the banking industry, which
means that a banking system with competition is more stable. Liu et al. (2011)
investigate the relation between competition and risk for the banking industry in
Southeast Asia, and find that competition does not increase banking risk.
There has been extensive empirical research on the relationships among market
power, bank efficiency and bank stability, but studies have mostly been limited to
developed countries. Studies on market power for the banking industry in China
mostly focus on measurement of overall market competition from a macroeconomic
point of view. For example, Yuan and Zhao (2007) analyze overall competition among
banks in terms of franchise value, concentration and regulatory capture and argue
that the influence of competition on bank stability is restricted by a variety of market
conditions and regulatory policies, and relationships between them cannot be deduced.
Ji (2007) uses a market power measurement model described by Nakane et al. (2006)
 and suggests that market power has a negative relationship with the rate of return on Chinese
assets in the Chinese commercial banking system and that joint-stock commercial commercial banks
banks are more efficient.
Now, Chinese banking industry, as described later, has been divided into three on efficiency and
types – state-owned banks, joint-stock banks and city banks – after several reforms. stability
The market power of state-owned banks is much higher than other types of bank. This
means that the Lerner index is useful when we study the market power of Chinese 311
banking. Moreover, competition-fragile theory and competition-stable theory may
also apply to Chinese banking sector because excessive competition squeeze the
profit margins of bank, and market power may induce high-risk loans and high-risk
investments.
Since the banking industry in China is not very mature and there are few public
data, we conducted the study with reference to the method of Turk-Ariss (2010).
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2. Market power of and its background

The financing structure of mainland China has changed from the single source of
commercial bank financing to the mixed pattern of sources in which commercial bank
financing, equity financing and bond financing complement each other. However, the
channel of financing is still dominated by commercial banks, especially the four big
banks (see Table I).
It is well known that market share is a key measure for market power of each
market participant. Table I shows that the ratio of indirect financing through
commercial banks has declined till the end of 2010, although the ratio is well above
74 percent. While the ratio of direct financing (stock þ corporate bonds) reached the
maximum of 26.0 percent in 2007 then declined to 23.9 percent, showing that the strong
market power of Chinese commercial banks.
However, the strength of the banking sector in China relies heavily on the market
power of state-owned commercial banks and corresponding institutions.
First, Table II shows that the total assets of Chinese banking sector account for over
90 percent of those in all financial institutions. In particular, the state-owned
commercial banks account for over 44 percent. On the contrary, joint stock and
city commercial banks along with securities and insurance companies possess a small

Increments in Domestic raised capital

commercial bank loans in stock market Corporate bonds
Year Amount Share Amount Share Amount Share

2003 27,702.3 95.9 823.10 2.8 358.0 1.2

2004 19,201.6 94.2 862.67 4.2 327.0 1.6
2005 16,492.6 87.4 338.13 1.8 2,046.5 10.8
2006 30,594.9 82.7 2,463.70 6.7 3,938.3 10.6
2007 36,405.6 74.0 7,722.99 15.7 5,058.5 10.3
2008 41,703.7 77.7 3,534.95 6.6 8,435.4 15.7
2009 95,940.0 81.7 5,051.51 4.3 15,864.40 13.6
2010 79,510.7 75.6 9,587.93 9.1 15,491.45 14.8 Table I.
The ratio of domestic
Notes: Amounts are in 100 million Chinese Yuan. Shares are in percentages equity financing, bond
Sources: China’s Financial Yearbook (People’s bank of China), China Statistical Yearbook of The financing and increments
Securities and Futures (China Securities Regulatory Commission) in commercial bank loans
 CFRI 2010 2009 2004 2003
4,4 Categories and year Amount Share Amount Share Amount Share Amount Share

Banks
State-owneda 458,814.6 44.2 400,890.2 45.7 169,320.5 51 161,228.7 55.5
Joint-stockb 148,616.9 14.3 117,849.8 13.4 46,972.2 14.2 28,880.2 9.9
312 City 78,525.6 7.6 56,800.1 6.5 17,056.3 5.1 14,621.7 5
Othersc 256,627.6 24.7 212,150.6 24.2 82,640.9 24.9 71,853.2 24.7
Subtotal 942,584.6 90.8 787,690.5 89.9 315,989.8 95.2 276,583.8 95.2
Securities and insurance
Insurance 50,481.6 4.9 40,634.8 4.6 11,953.7 3.6 9,088 3.1
Securities 19,665 1.9 20,286.9 2.3 3,663.8 1.1 4,826.7d 1.7
Futures 304.1 0 1,207.3 0.1 212.2 0.1 – –
Fund management 24,972.5 2.4 26,695.4 3 3,258.1 1 – –
Subtotal 95,423.2 9.2 88,824.4 10.1 15,915.1 4.8 13,914.7 4.8
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Total 1,038,007.8 100 876,514.9 100 331,904.9 100 290,498.5 100

Notes: Amounts are in 100 million Chinese Yuan. Shares are in percentages. aState-owned commercial
banks includes: Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China,
China Construction Bank and Bank of Communications; bnationwide joint-stock commercial banks
include: CITIC Bank, Everbright Bank of China, Huaxia Bank, China Guangfa Bank, Shenzhen
Development Bank, China Merchants Bank, Shanghai Pudong Development Bank, Industrial Bank,
China Minsheng Bank, Evergrowing Bank, Zheshang Bank and Bohai Bank; cother institutions
include: policy banks, rural commercial banks, rural cooperative banks, foreign-invested banks, urban
Table II. credit unions, rural credit unions, finance companies, trust and investment corporations, finance lease
Amounts of total assets companies, automotive finance companies, money broking companies and Postal Savings Bank of
of domestic financial China; dinclude future companies and fund management companies
institutions Sources: Web site of People’s bank of China, web site of China Banking Regulatory Commission

proportion of assets: the figure is only 9.2 percent by the end of 2010. The exact pattern
illustrates that the relative magnitude of state-owned commercial banks in the banking
system is high and the banking sector is considerably concentrated which lead to their
prominent degree of market power.
Second, market power of state-owned commercial banks in China is obtained by
China’s ownership structure reform process and direct administrative intervention
rather than competition, which is totally different from that in developed countries. In
the reform which has lasted for over 30 years, four state-owned specialized banks:
Agricultural Bank of China, China Construction Bank, Bank of China and Industrial
and Commercial Bank of China were primarily re-established to take over the banking
business of the People’s Bank of China. They were converted into commercial banks
later and finally became listed companies. In addition, 13 nationwide joint-stock
commercial banks were established during the reform. To complement the banking
capital of state-owned banks, the central government issued 270 billion yuan of special
treasury bonds in 1998. One year afterward, 1.4 trillion yuan of non-performing loans
were acquired by four newly established asset management companies. To facilitate
the stock right splitting reform, 60 billion US dollars and 130 billion yuan were injected
into state-owned banks via an investment vehicle by the central government since the
end of 2003. Meanwhile, Bank of China and China Construction Bank issued 14 billion
and 35 billion of subordinated debts, respectively, to supplement Tier 2 Capital with
the help of governmental measures. The reform finished in 2010 when Agricultural
Bank of China successfully launched its IPO.
 Third, under the existing legal framework, divided operation is implemented in Chinese
China’s financial sector. The reason for this legal arrangement dates back to the early commercial banks
period of opening and reform when the economic bubble appeared due to the flow of
money from banking sector to the stock market in the context of ineffective monitoring on efficiency and
and inspection measures by the central bank and the mixed operation of the financial stability
sector at that time. In 1995, the third meeting of the Eighth National People’s
Congress approved “Law on the People’s Bank of China,” “Law on Commercial Banks” 313
and “Insurance Law.” According to Article 3 of the Law on Commercial Banks,
“a commercial bank may have the following businesses in part or in whole: absorbing
public deposits; offering short-term, medium-term and long-term loans; arranging
settlement of both domestic and overseas accounts; handling acceptance and discount
of negotiable instruments; issuing financial bonds; issuing, cashing and undertaking
the sale of government bonds as agents; buying and selling government bonds or
financial bonds; undertaking inter-bank borrowing or lending; buying and selling
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foreign exchange by itself or as agents; engaging in bank card business; offering

L/C services and guarantee; handling receipts and payments and insurance business
as agents; providing safe boxes services; and other businesses as approved by the
banking regulatory organ of the State Council.” Meanwhile Article 43 stipulates
that “no commercial banks shall undertake the businesses of trust and investment
and securities dealing business, nor shall they invest in the non-self-use real
property or non-bank financial institutions and enterprises, unless it is otherwise
prescribed by the state.” Therefore, the main reason for adoption of divided
operation in the financial sector in China is not only to stabilize domestic financial
environment to achieve a “soft landing” of the economy, but also to protect the
domestic financial institutions. Nevertheless, the policy hinders commercial
banks from operating securities business by establishing non-bank subsidiaries,
which in turn forces them to focus on traditional banking business such as deposits
and loans.

3. Variables and model

Bank efficiency
Bank efficiency is usually assessed using two methods: DEA, which is deterministic
and non-parametric, and stochastic frontier analysis (SFA), which is stochastic and
parametric. The former has the advantage on flexibility, without assuming a particular
form of the production function. However, in DEA, it is assumed that efficiency is not
affected by random fluctuations, and all deviations from the efficient frontier are
generated by the inefficiency factors, so the measurement error of DEA is much greater
than SFA. In SFA, inefficiency and random error are component parts of a composite
error term by making explicit assumptions about their distributions. Thus, SFA is
more applicable to operating efficiency of banking sector.
According to economic theory, to maximize profit, commercial banks pursue a
maximum output under a fixed input or a minimum cost under a fixed income. Battese
and Coelli (1992) argue that there is an efficiency frontier in bank management that
represents the optimum efficiency level that a bank can reach under current technical
conditions. Some banks cannot reach this frontier for two main reasons: random
disturbance and technical non-efficiency. After making a reasonable assumption
for the disturbance term and using bank inputs and outputs to establish a SFA model,
the relative efficiency of banks can be calculated to reflect the efficiency level of
bank management.
 CFRI Thus, we used an SFA model to evaluate the cost and PE of commercial banks with
4,4 reference to the frontier function form of Battese et al. (2004). Assuming that banking
costs (Cost) are a function of output (Q for total assets) and three input prices (w1 for the
price of labor, w2 for the price of fixed assets and w3 for the price of liabilities), we
establish the translog cost function as follows:

314 b2
ln Costit ¼ b0 þ b1 ln Qit þ ðln Qit Þ2 þ b3 ln W1it þ b4 ln W2it þ b5 ln W3it
2
b b b
þ 6 ln W1it ln W2it þ 7 ln W1it ln W3it þ 8 ln W2it ln W3it ð1Þ
2 2 2
b9 b10 b11
þ ln Qit ln W1it þ ln Qit ln W2it þ ln Qit ln W3it þ eit
2 2 2
All the variables in (1) are described in Table III; subscripts i and t denote bank i and
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time, respectively, and eit is an error term, which is divided into a random disturbance
term vit and a technical non-efficiency term uit. We assume that vit and uit have a
normal distribution and a truncated normal distribution, respectively:

eit ¼ vit  uit ð2Þ

vit  N ð0; s2v Þ ð3Þ

uit  N þ ðmit ; s2u Þ ð4Þ

and:
mit ¼ a0 þ a1 Asit þ a2 Shareit þ a3 Trendit þ a4 Ecit ð5Þ

Equation (5) is explained as follows. Since many external factors can influence bank
efficiency, a time tendency item Trend is added to show the degree to which bank
efficiency changes over time. The level of management and public supervision for a
listed company may promote its efficiency to some extent, so the variable Share is used
to differentiate between listed and unlisted banks. In addition, to reflect the influence of
scale differences and macroeconomic development conditions on bank efficiency, the
bank’s asset share of all banking As and an economic cycle variable Ec are included in
the equation.
The CE (e ¼ v þ u) of each bank can be estimated using a maximum likelihood
estimation method for (1); PE (e ¼ v–u) can be estimated in the same way using profit
before tax (Pbt) instead of Cost.

Market power
In this paper, market power is measured using the Lerner index, defined as:
Lernerit ¼ ðPit  MCit Þ=Pit ð6Þ

The Lerner index measures the degree of deviation of the product price P from
the marginal cost MC for bank i at time t. The higher the product price or the lower the
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Symbol Variable Value Symbol Variable Value

Cost Total cost Interest expense þ service fee L Loans Total loans
expenses þ other operating
expenses þ non-operating
expenses
Pbt Profit before tax Profit before tax D Deposits Total deposits
TR Total revenue Interest revenue þ other operating y CE Value of cost Obtained by (1)
income þ non-operating income efficiency
Q Total assets Total assets PE Value of profit Obtained by (1)
efficiency
W1 Price of labor Payroll/number of employees Z Z index for stability Obtained by (9)
(“payroll” is substituted with
“other operation expenses”
(in China) or “total operating
expenses”(in Hong Kong), because
it is unavailable)
W2 Price of fixed assets Depreciation/fixed assets Market power Lerner Lerner index for Obtained by (6)
market power
W3 Price of liabilities Interest expense/total liabilities (Lerner)2 Squared term
As Assets share Assets of bank i/sum of all banks Bank control lnQ Natural logarithm of
in sample Q
Trend Time trend term L/D Rate of loans to Loans divided by
deposits deposits
EC Economic cycle 1 for a year’s GDP growth rate is As Assets share As above
higher than the average growth
rate of GDP in sample, 0 elsewhere
Share Listed 1 for listed banks, 0 elsewhere Outside environment Area Indicator of Hong 1 for Hong Kong
Kong banks banks, 0 elsewhere
on efficiency and

in the paper
Variables used
stability

Table III.
315
Chinese
commercial banks
 CFRI marginal cost is for a bank, the greater is the Lerner index is and the stronger is the
4,4 competitive ability and market power of the bank.
In (6), the price of bank products is defined as total revenue divided by total assets:

Pit ¼ TRit =Qit ð7Þ

316 MCit is the marginal cost, which can be calculated as:

 
Cost b b b
MC ¼ b1 þ b2 ln Q þ 9 ln Q ln W1 þ 10 ln Q ln W2 þ 11 ln Q ln W3 ð8Þ
Q 2 2 2

Bank stability
The Z-index described by Boyd and De Nicolo (2005) is used to measure the stability
of bank management and is defined as:
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ROAi þ Ei =Qi
Zi ¼ ð9Þ
siROA

where Zi is the Z-index for bank i, ROAi and Ei =Qi are the mean return on assets
and ratio of equity to assets, respectively, for bank i during the sample period, and
siROA is the ROA standard deviation for bank i during the sample period.

4. Data and method

Data
We used annual financial data from 2000 to 2009 for 21 commercial banks, including
four state-owned commercial banks and 17 joint-stock and city commercial banks on
the Chinese mainland among which four joint-stock and city commercial banks were
established relatively late, whose financial information start from 2002 or 2006.
Statistical data show that at the end of 2009, these 21 commercial banks accounted
for 75 percent of the deposit market and 80 percent of the loan market in China and
are thus representative of the Chinese banking sector. In addition, in order to better
illustrate the performance of Chinese commercial banks, and make a benchmark which
is relatively close to international standards for efficiency frontier, we choose 11
samples of commercial banks in Hong Kong. One of the reasons is that their financial
information is easily accessible, and the other is that the banking market in Hong Kong
is more market oriented and the economy is much closer to the international standard.
The four large state-owned banks (classified as state-controlled banks after 2009)
mentioned above include: Industrial and Commercial Bank of China, Agricultural
Bank of China, Bank of China and China Construction Bank. The 17 joint-stock and
city commercial banks include: Industrial Bank, China Guangfa Bank, Bank of
Communications (classified as state-controlled banks after 2009), Shanghai Pudong
Development Bank, Shenzhen Development Bank, China Minsheng Bank, China
Merchants Bank, CITIC Bank, Everbright Bank of China, Huaxia Bank, Shanghai
Rural Commercial Bank, Chongqing Bank, Bank of Ningbo, Bank of Beijing, Bank of
Shanghai, Evergrowing Bank and Zheshang Bank. The 11 Hong Kong’s commercial
banks include: Hang Seng Bank, Bank of East Asia, Wing Lung Bank, Wing Hang
Bank, ICBC (Asia), HSBC, Public Financial Holdings, Fubon Bank, Chong Hing Bank,
Dah Sing Bank and BOC Hong Kong.
 All of the data were obtained from the GuoTaiAn database or financial statement Chinese
in annual report, and were adjusted using a GDP deflator index according to commercial banks
international practice.
on efficiency and
Method stability
First, in the cost function of Equation (1), the total assets are used as the measure of the
product. The revenues of banks are composed from interest revenues and non-interest 317
revenues; the amount of interest revenues is only closely related with the amount of
the total assets. Taking into consideration that the structures of revenue may differ
between Chinese banks and Hong Kong banks which may affect the estimation of bank
efficiency, we use the shares of net interest revenues of sample banks (the ratio of net
interest revenue to operating income before tax) as the measure of structure of revenue,
in which net interest income is defined as interest income minus interest expense.
Mann-Whitney U-test is then employed to assess whether the structures differ between
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samples from two regions since the test does not require that random variables follow
normal distribution and it is suitable for the unpaired independent observations.
To discuss the influence of market power on cost efficiency, PE and bank stability,
we first estimated each index using the model above and then analyzed them by
regression as follows:
. Step 1: estimate efficiency model (1) using panel data and SFA Frontier 4.1
software to obtain the value of b.
. Step 2: estimate the market power model:

CE; PE; Z ¼ b0 þ b1 Lerner þ b2 Lerner2 þ b3 InQ þ b4 L=D

ð10Þ
þ b5 As þ b6 Area þ e

to analyze the functional relationship between Lerner and CE, PE and Z using
cross-sectional data. In Formula 10, e is error term; b1, b2, b3, b4, b5 and b6 are
the coefficients of the variables, respectively. All the variables in (10) are described
in Table III.

5. Results
Statistical analysis of revenue structures
SPSS Software is used to conduct statistical analysis on revenue structures. The
descriptive statistics of share of net interest revenues of sample banks from mainland
China and Hong Kong in the period between 2002 and 2009 are presented in Table IV.
Table IV illustrates that except for the year of 2004, the shares of net interest
revenues of banks in mainland China differ from those of their Hong Kong
counterparts in general. Specifically, the shares of banks in mainland China are
significantly larger than those of Hong Kong banks in 2005 and 2006 while the opposite
is true in 2002, 2003, 2007, 2008 and 2009. This may be explained by the fact that the
variation of the shares of net interest revenues across time is relatively large. In the
period between 2002 and 2009, the volatility (variation) of the ratios of Hong Kong
banks is 0.3501; the figure is 0.0357 for Chinese banks. The low value for Chinese bank
may stem from the fact that the ability of Chinese banks to generate non-interest
revenues is relatively low since the mixed business was gradually introduced into
Chinese banking sector after the full implementation of WTO commitments. On the
 CFRI contrary, divided operation is not implemented in Hong Kong banking sectors.
4,4 Banking groups in Hong Kong can offer various financial services such as commercial
banking, investment banking and insurance. Their interest revenues substantially
declined in 2004 due to the structural changes in trade patterns, decline in real estate
prices and the prevalence of equity financing (Zhang, 2004). However, since the second
half of 2008, the investors’ confidence was struck by the global financial crisis and
318 huge amount of funds was transferred from wealth management into savings. Thus,
the huge decrease in non-interest revenues raised the shares of net interest revenues.
Furthermore, standard deviations indicate that the shares of Chinese banks are similar
to each other, while those of Hong Kong banks vary a lot.
The results of the Mann-Whitney U-test for the shares of interest revenues of
Chinese banks and Hong Kong banks are given in Table V. Except for the year of 2009,
all the other p-values are much larger than 0.05. We cannot reject the null hypothesis
that there are no significant differences between the shares of net interest revenues of
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banks in two regions. We can conclude that the revenue structures are the same
between banks from two regions which in turn justifies the use of total assets as the
measure of output in Equation (1).

Index estimates
First we discuss efficiency. Table VI shows the parameters estimated using model (1).
The LR-statistic is significant at the 1 percent level, which refutes the hypothesis of
g ¼ 0 and proves the objective existence of a technical non-efficiency term and the
validity of the SFA model. Meanwhile, estimates of g according to the two models are
0.950 and 0.961, both of which are statistically significant, which means that the
technical non-efficiency term has a significant influence on cost efficiency and PE and
that B95-96 percent of the errors are caused by it. Second, 24 of the total 34 parameters
are significant at the 5 percent level. The reason why ten parameters are not significant
may lie in multicollinearity due to the translog function form, whose existence,
however, has no influence on the consistency of parameters (van der Hoek and
Wooldridge, 2003). Multicollinearity refers to a situation, in which two or more

Region 2002 2003 2004 2005 2006 2007 2008 2009

Mainland China 1.87 1.86 1.54 1.71 1.79 1.53 2.01 1.5
Table IV. (0.69) (0.74) (0.50) (0.84) (0.92) (0.60) (2.56) (0.40)
Descriptive statistics of Hong Kong 2.36 2.49 1.45 1.44 1.43 1.97 3.07 2.12
shares of net interest (2.17) (2.63) (0.48) (0.32) (0.33) (1.03) (27.07) (5.94)
revenues of sample banks
(2002-2009) Note: Mean values are reported while standard deviations are in parentheses

2002 2003 2004 2005 2006 2007 2008 2009

Table V. Mann-Whitney U 67 76 82 95 85 80 90 66
Results of the Wilcoxon W 172 196 148 161 151 311 321 297
Mann-Whitney U-test Z 0.547 0.337 0.026 0.409 1.210 1.408 1.012 1.964
for revenue structures Asymptotic significance 0.584 0.736 0.979 0.683 0.226 0.159 0.312 0.05
between two regions Exact significance 0.609 0.76 1 0.703 0.238 0.168 0.327 0.051
 Variable Coefficient Cost efficiency model Profit efficiency model
Chinese
commercial banks
C1 b0 5.3527 (1.9142)*** 8.772 (3.7485)**
lnQ b1 0.5383 (0.1930)*** 1.3208 (0.3514)***
on efficiency and
1
2(lnQ)
2
b2 0.0675 (0.0129)*** 0.0959 (0.0200)*** stability
lnW1 b3 0.0668 (0.5936) 3.0042 (0.1622)***
lnW2 b4 0.5199 (0.4888) 0.0798 (0.8549) 319
lnW3 b5 0.2654 (0.0300)** 0.0168 (0.0068)**
1
2lnW11nW2 b6 0.4774 (0.3053) 0.0469 (0.0592)
1
2lnW11nW3 b7 0.0726 (0.0147)** 0.1450 (0.0249)**
1
2lnW21nW3 b8 0.0222 (0.0083) 0.2609 (0.2079)*
1
2lnQ1nW1 b9 0.0465 (0.0553) 0.5971 (0.0997)***
1
2lnQ1nW2 b10 0.0951 (0.0390)* 0.0448 (0.0123)
1
2lnQ1nW3 b11 0.0386 (0.0583) 0.0662 (0.0885)
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C2 a0 1.0158 (0.0707)*** 2.1966 (0.3263)***

As a1 0.9291 (0.0867)*** 0.1105 (0.0833)*
Trend a2 0.0123 (0.0490) 0.5118 (0.1666)***
Share a3 0.0123 (0.0015)*** 2.4877 (1.0464)**
Ec a4 0.1128 (0.0488)** 0.6214 (0.3600)*
g 0.9495 (0.0429)*** 0.9605 (0.0182)***
LR 175.787*** 147.040***
Notes: The numbers in parentheses are standard deviations. g ¼ s2u/(s2u þ s2v) measures the ratio of
variance of technical non-efficiency term (s2u) to the variance of error term (s2u þ s2v); LR is the statistic Table VI.
of the one-sided likelihood ratio test of g, and LRBw2(n). *,**,***Denote significant level of 10, 5 Estimated results for
and 1 percent, respectively efficiency models

explanatory variables in multiple regression model, are highly linearly related. In the
absence of the case of perfect collinearity, the OLS estimator remains unbiased and in
fact is still the BLUE (Kennedy, 2003). Namely, an approximate linear relationship does
not mean any change of OLS assumptions, although multicollinearity often leads to
greater variance of parameter estimates. And in our empirical analysis, the key
parameters we focus on are statistically significant.
The value of CE varies from 1 to infinity and cost efficiency is much lower
if CE is closer to 1. The value of PE varies from 0 to 1 and PE is much higher if PE is
closer to 1. Figures 1 and 2 show annual trends for cost efficiency and PE according to
the Frontier 4.1 output.
Figure 1 shows that the cost efficiency of the four state-owned commercial banks
(called the four big banks hereafter) is slightly lower than that of the 17 joint-stock
commercial banks (called medium and small banks hereafter). However, the cost
efficiency of most banks showed an increasing trend after 2002, which means that
Chinese banking reform has led to great progress since the country entered the WTO,
and the leverage of banking management and the ability to control costs have greatly
improved. However, compared with banks in Hong Kong, the cost efficiency of banks
on the mainland is still much lower, which indicates that Chinese banking reform still
has a long way to go.
Figure 2 reveals that the PE of banks on the Chinese mainland, which is much lower
than that of Hong Kong banks, constantly increased. This is especially true for the four
big banks, whose PE exceeded that of medium and small banks in 2007. This is mainly
because: the four big banks had higher input and lower efficiency before China entered
the WTO; banking reform intensified with opening of the banking market and
 CFRI 3.5
4,4
3

2.5
320
Cost Efficiency 2

1.5
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1
Four big banks

0.5 Small banks

HK banks

Figure 1. 0
2000

2002

2008
2001

2003

2004

2005

2006

2007

2009
Estimated values of
cost efficiency
Year

0.9

0.8

0.7
Profit Efficiency

0.6

0.5

0.4

0.3
Four big banks
0.2
Small banks
0.1 HK banks

Figure 2. 0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Estimated values
of profit efficiency
Year
 increasing competition from foreign banks; and the four big banks have wide outlet Chinese
coverage, a large local customer base, and a better administration structure and commercial banks
decision mechanism after being listed through the use of foreign capital, all of which
helped the four big banks to use existing techniques, talented personnel and customer on efficiency and
resources to improve their operating capital and PE. stability
In contrast, the PE of Hong Kong banks fell steeply in 2007-2008 after a long period
of stability. In our opinion, the US subprime crisis, which caused a worldwide financial 321
crisis, is the direct reason for this. As a highly free market, the Hong Kong banking
sector suffered a serious impact because the market self-regulation function had an
obvious limitation in the short term. The banks in mainland China escaped the crisis
because of the incomplete Chinese market and timely macrocontrol efforts by the
Chinese government.
The yearly Lerner index for each bank was calculated using Equations (6), (7) and
(8). The data in Figure 3 indicate that the market power of the four big banks fell
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slowly in 2000-2007 during the process of commercial banking reform and has been
steady since 2007. Medium and small banks, despite much smaller market power,
benefitted from banking liberalization and became more competitive, which can be
inferred from their improving market power.

The influence of market power

Table VII reports the estimation results for the market power model, namely
Equation (10).
We first discuss the relationship between market power and cost efficiency. When
CE is the dependent variable, the coefficient for (Lerner)2 is positive and the infection
point is 0.392. That is, 0.392 is the inflection point of the relation curve between
Lerner index and CE. When b2 – the coefficient of (Lerner)2 – is positive, CE has a

0.7

0.6

0.5

0.4
Lerner

0.3

0.2
Four big
0.1 banks

0
Figure 3.
2002
2001

2003

2004

2005

2006

2007

2008

2009
2000

Estimated values
of market power
Year
 CFRI CE PE Z
4,4
C 1.8395 (0.3870)*** 0.1860 (0.0579)** 17.993 (3.2665)***
Lerner 3.1219 (1.0910)** 0.3980 (0.0633)** 87.886 (9.2095)***
(Lerner)2 3.9690 (1.4919)* 0.6416 (0.2233)** 93.76 (12.5940)**
lnQ 0.1710 (0.0385)*** 0.0619 (0.0058)*** 1.710 (0.3247)***
322 L/D 0.2326 (0.1971) 0.0061 (0.0259) 6.793 (1.6636)***
As 1.8322 (0.6285)** 0.8242 (0.0940)*** 14.162 (5.3052)*
Area 1.2262 (0.1154)*** 0.1114 (0.0173)*** 4.3749 (0.9742)***
R2 0.9511 0.8856 0.9541
F 101.5228*** 41.0033*** 108.5996***
Inflection point 0.3924 0.3085 0.4692
Table VII. Sign of relationship þ  þ /
Estimated results of
market power models Notes: *,**,***Denote significant level of 10, 5 and 1 percent, respectively
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positive relationship with Lerner index if the value of Lerner index40.392. All the
market power data are distributed to the right of the infection point, which indicates
that Lerner has a remarkable positive relationship with CE and thus a remarkable
negative relationship with cost efficiency. Cost efficiency decreases as market
power increases.
Similarly, data in the third column of Table VII show that PE decreases as market
power increases.
Therefore, in the banking sector for mainland China and Hong Kong, banks
with greater market power always have lower cost and PE. Banks with no
market power advantage have to improve their efficiency to survive under intense
competition.
The empirical results do not totally agree with the efficient structure hypothesis.
One of the key reasons, from our point of view, is that the monopoly concept in the
efficient structure hypothesis refers to monopoly generated from long-term competition
in a competitive market. In the Chinese banking market, however, the four big banks
have the greatest market power, but this is a result of a planned economy and a
transitional market economy and has remarkable administrative characteristics. In
other words, the market power of the four big banks does not arise from high
monopoly earnings through high prices and high-quality services. Thus, although the
four big banks have dominated market power and market share, their cost and
PE are still not as good as those of medium and small banks, which grew up in a
competitive market.
Finally, we analyze the relationship between market power and bank stability using
Z as the dependent variable. The last column of Table VII shows that the coefficient for
(Lerner)2 is negative and the inflection point is 0.469. An interesting phenomenon is
that 84.5 percent of the market power data are distributed to the left of the inflection
point, which means that Z first increases and then decreases as Lerner increases.
When less than a particular value (0.469 here), market power has a positive
relationship with bank stability, which supports the competition-fragile theory and
indicates that competition forces banks to face more risks. However, when it exceeds
this particular value, market power has a negative relationship with bank stability,
which is consistent with competition-stable theory. Why does this happen? We can
identify the reason without much effort. The data to the right of the inflection point
correspond to the four big banks and another big bank (Bank of Communications).
 These five largest banks have the strongest market power and the lowest cost and PE. Chinese
More importantly, they have to distribute funds according to the financial management commercial banks
and economic policies of state institutions, which leads to a weak ability to control
risk and to many non-performing loans. Stability is thus weakened, especially for on efficiency and
the Agricultural Bank. If medium and small banks and Hong Kong banks could stability
successfully gain some market power, then their ability to control risk would improve
and bank stability would greatly increase. 323
6. Conclusions
The Lerner index and Z-index were used to measure the market power and stability of
Chinese banks. An SFA model was established to determine efficiency and financial
data for 21 commercial banks on the Chinese mainland and ten banks in Hong Kong
for 2000-2009 were used to test the traditional efficient structure hypothesis and the
competition-fragile and competition-stable hypotheses. From the results, the following
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conclusions can be drawn:

. For both mainland and Hong Kong banks, the relationship between market
power and efficiency (cost and profit) is inconsistent with the traditional efficient
structure hypothesis. Banks with more market power are always too dependent
on their monopoly position and have no motivation to improve cost and PE;
banks in a position of competition, however, have better management ability and
higher cost and PE.
. The four state-owned commercial banks have strong market power but
relatively low cost and PE. This is possibly because of the particularities of
Chinese banking development and administrative market power. With the
intense property rights reform of state-owned commercial banks in recent years,
administrative market power has been weakening, which makes the four
state-owned commercial banks lose some market power and gain some efficiency
improvement in intense competition.
. On the whole, the cost and PE of banks on the Chinese mainland are increasing,
but still lag behind those of banks in Hong Kong.
. The traditional competition-fragile theory argues that excessive competition will
erode the market power of banks and decrease profit stability and thus increase
overall bank risks, which is proved for Chinese medium and small banks.
However, data also provide some support for the competition-stable theory,
according to which, when banks have more market power, they may have a
weaker ability to control overall risk, which would destroy their stability. Thus,
if properly introduced, competition will have a positive impact on the stability of
the four state-owned commercial banks.

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About the authors

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Xiangning Wang is an Associate Professor, Department of Statistics and Finance, The School of
Management, University of Science and Technology of China. Associate Professor Xiangning Wang
is the corresponding author and can be contacted at: wangxn@ustc.edu.cn
Dr Xianming Zeng is a PhD Candidate, Department of Statistics and Finance, The School of
Management, University of Science and Technology of China.
Dr Zhiyang Zhang is an Investment Analyst, Shenzhen Marketing Centre, Guosen Securities
Company Limited.

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