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2008 Dec/29
Analysis and Implications for changing the degree of competition in the Korean Securities Industry
Research Papers 08-05
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- Research Topic Financial Services Industry
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Park, Shin Ae
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- Summary
- The financial environment of the securities industry was in flux for about a decade beginning in the mid-nineties. In other words, the securities industry saw a more competitive environment due to the deregulation of brokerage rates in the late 1990s, the increased presence of online trading, and lower entry barriers for securities firms. This report examines whether these environmental changes actually increased competition in the securities industry in the 2000s. By using the Panzar-Rosse methodology to measure the degree of competition in the domestic securities industry, our results show that it increased significantly in the early 2000s and has even indicated close to perfect competition. The increase in competition degree of the whole industry reflects that price competition increased for brokerage, underwriting, fund sales and almost all other businesses. The homogenization of the brokerage businesses which is the main revenue source for securities firms is likely to be the most important factor of increasing competition within the securities industry. In combination with the regulatory changes that encouraged price competition, the growth of online trading exacerbated the monopoly power of brokerage businesses through the person-to-person approach and branch networks. It is widely believed that the marginal cost of the online trading service, which is close to zero, inevitably furthered the price competition. The underwriting service was also in similar price competition environments. Domestic securities firms mostly competed for their underwriting business by providing plain vanilla types of services that did not require any risk taking. This trapped their underwriting services in a homogenous group, and as a result they had no choice but face fierce price competition. The higher entry barriers and thus the decreased number of securities firms might not stop the price competition that resulted from the homogenization of services in the domestic securities industry. In fact, our estimates of competition after heightened entry barriers are a little higher. This result is consistent with the Bertrand paradox which states the number of firms is no longer an important factor driving price competition once products and services are homogenized and more than two competitors exist. From this perspective, protection of the securities industry from over-competition may not be achieved by government regulations such as entry barrier policies that decrease price competition. Rather, this may increase the license premium of the securities firms as a side effect. In fact, the existence of the license premium could be confirmed from the fact that despite weak revenue structures, stock prices of small and medium size of securities firms` have increased more than large firms during periods with high entry barriers. Considering that capital, the number of branches, and total employees are factors increasing monopoly power, we also analyzed how the competition securities firms faced varied with their capital size. The results show that competition conditions of 3 big securities firms changed from monopoly in late 1990s to monopolistic competition in early 2000s, while that of small or medium sized firms changed from monopolistic competition to perfect competition. This implies that although both groups faced higher competition in the early 2000s, small or medium size firms competed more severely and thus needed strategies to survive. In attempt to examine factors behind the change of competition conditions in the securities industry, we estimated the demand function of brokerage services over 1992-1996 (1st period), 1997-2001 (2nd period) and 2002-2006 (3rd period), respectively. According to the results, the price elasticity of demand was higher in the 2nd period than in the 1st period, experiencing deregulation on commission fees and the introduction of online trading. The cross elasticity of demand jumped up in the 3rd period, when online trading services were fully developed by almost all securities firms. It is inferred that the online trading services affected consumer price sensitivity through the homogenization of the brokerage service, which triggered competitive brokerage rates in combination with the deregulation of commission fees. As a result, lower brokerage rates reflected the change in the consumer behavior showing price sensitivity. However, without considering the cost side, it is still an open question whether securities firms’ prices have been close to the ir marginal costs despite lowered prices responding to these changes in the demand function. Therefore, the cost function of brokerage services might need to be examined. Estimates of the marginal cost of brokerage services decreased significantly for most firms after the introduction of online trading services. In particular, in 1999 and 2000, the cost drop allowed many securities firms to obtain higher profits despite price reduction. However, since 2000, the securities firms have faced lower markups as the price decreased steadily despite stable marginal cost. Furthermore, it shows that securities firms don’t have much space to decrease brokerage fees and the increase in price competition triggered by external factors, probably forces securities firms to accept lower profits. It suggests that individual cost efficiency through synergy or management should be the most important strategy to survive in the brokerage business in the future. Finally, the average cost estimates of the brokerage business indicate that the average cost of large firms is the lowest and those of small firms are the highest. The slope of the average cost function of small or medium size firms is much steeper than that of large securities firms. Its implication is that small or medium size firms are more likely to be faced with loss by an increase in the average cost when stock markets are down. As a result, with their disadvantage in retail brokerage services, small or medium size firms should focus on a special area that they have an advantage in or circumvent direct competition against large size firms, for instance, serving clients such as small or medium enterprises.