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What barriers to entry exist in the financial services sector?

Modified on: 2018/07/12
A:

Barriers to entry in financial services markets include licensure laws, capital requirements, access to financing, regulatory compliance and security concerns. Among different market sectors, the financial services sector has a uniquely complicated relationship with competition and barriers to entry. This is largely owed to two factors: the perception of banks and other financial intermediaries as a driving force behind economic stability or instability and a prevailing theory among many policymakers that "excessive competition" in financial services is deleterious to overall sector efficiency.

Theory and Competition

Many neoclassical and free-market economists have argued that increased competition in financial services would lead to lower costs and improved efficiencies. These arguments assert that the incentives of free competition can create an atmosphere among financial intermediaries that would improve quality, customer responsiveness and product innovation. The theoretical models of Besanko and Thakor (1992) further suggest that financial products and capital structures are heterogeneous and a relaxing of entry barriers would lead to declining loan costs and increasing interest rates on depository accounts. This, ultimately, would lead to higher growth rates in the greater economy.

The broader academic and policymaking community, however, argues that competition and stability are not perfectly correlated in financial services. Some suggest franchise value is important for maintaining incentives for prudent behavior. This not only leaves room for financial regulators to balance exit and entry in the industry but rather compels the implementation of stability-conscious regulations. This viewpoint is particularly strong when applied to banking, where market concentration might make banks choose to pursue safer lending practices.

Types of Barriers to Entry

The specific barriers to entry that exist are different among separate financial services industries. For example, the barriers for new banks are different than barriers for new broker-dealers or insurance companies. Many differences also exist in different states, countries and economic climates. It is widely accepted that technology and globalization change the nature of competition in the financial services sector, without agreement as to what those changes might entail.

It is generally very expensive to establish a new financial services company. High fixed costs and large sunk costs in the production of wholesale financial services make it difficult for startups to compete with large firms that have scale efficiencies. Regulatory barriers exist between commercial banks, investment banks and other institutions and, in many cases, the costs of compliance and threat of litigation are sufficient to deter new products or firms from entering the market.

Compliance and licensure costs are disproportionately damaging to smaller firms. A large-cap financial services provider does not have to allocate as large of a percentage of its resources to ensure it does not run into trouble with the Securities and Exchange Commission (SEC), Truth in Lending Act (TILA), Fair Debt Collection Practices Act (FDCPA), Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC) or a host of other agencies and laws.

It should be noted that deregulation movements in financial services were strong for the period between 1980-2007. A 2003 study of U.S. branching deregulation found that the abolishment of intrastate and interstate banking restrictions was followed by "better performance of the real economy." State economies grew "faster," and "macroeconomic stability improved."

Concerns about deregulation re-emerged in the aftermath of the 2008 financial crisis. Whether increased scrutiny or regulation on financial services providers creates unwanted barriers to entry is a subject of much debate.


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