Competitive conditions and market power of Islamic and conventional commercial banks in Indonesia

Abstract

The expansion of the Islamic banking industry seems to accentuate banking competition in Indonesia where conventional and Islamic banks coexist. In addition, the 2007/2008 global financial crisis and deregulation have effected the competitive conditions in the banking sector of Indonesia. In this context, this study aims at examining the competitive conditions and the market power of Islamic and conventional banks using firm level data over the period 2006-2013 in Indonesia. The study also attempts to identify the determinants of market power of banks in Indonesia. Using a sample of 27 Islamic banks and 106 conventional commercial banks, the study uses a variety of structural and non-structural measures related to the traditional approach and the new empirical approach of industrial organization. The methodology is based on a set of measures of competition and market power. The first measure is a set of concentration ratios (CR4) and the Herfindahl-Hirschman index (HHI).The second measures are the Panzar and Ross H statistic, the Boone indicator and the Lerner index based on econometric estimations with the aim of evaluating the structure of market and measuring its power in terms of price setting. The results of the competition analysis suggest that the banking markets of Indonesia cannot be characterized by the bipolar cases of either perfect competition or monopoly over 2006-2013. That is, banks earned their revenues as if operating under conditions of monopolistic competition in that period. Overall, Islamic banks in Indonesia operate in a relatively less competitive environment compared to conventional banks, or in other words, market power is higher in Islamic markets compared to conventional commercial markets. The study also show that profitability significantly increases with market power, but this does not warrant higher profitability levels for Islamic banks. The study is expected to serve as future reference for researchers on the subject of Islamic banking and finance. The study can also contribute to policy makers on how they should manage the financial system by avoiding financial distress and adjust successfully to the expected new competitive environment, on how they should design and implement the competitive policies, and appropriate supervisory and regulatory framework and how they should enforce market discipline to promote banking industry competition.