What barriers to entry exist in the financial services sector?

In the financial services markets, barriers to entry include licensure laws, capital requirements, access to financing, regulatory compliance and security concerns.

The financial services sector has a uniquely complicated relationship with competition and barriers to entry. This is largely due to two factors. One factor is the perception of banks and other financial intermediaries as a driving force behind economic stability or instability. A second factor is the prevailing theory among many policymakers that "excessive competition" in financial services is deleterious to overall sector efficiency.

Key Takeaways

  • Free market economists believe that relaxing of barriers to entry will lead to declining loan costs and increasing deposit interest rates on bank accounts.
  • However, the prevailing view among policymakers is that excessive competition is deleterious to overall efficiency in the financial services sector.
  • Compliance and licensure costs disproportionately burden smaller firms and start-ups, which may not have the scale to overcome high fixed costs and sunk costs.

Theory and Competition

Many neoclassical economists and free-market economists argue that increased competition in financial services will lead to lower costs and improved efficiencies. These arguments assert that the incentives of free market competition can create an atmosphere among financial intermediaries that will improve quality, customer responsiveness and product innovation.

The theoretical models from economists David Besanko and Anjan Thakor further suggest that financial products and capital structures are heterogeneous and a relaxing of entry barriers will lead to declining loan costs and increasing deposit interest rates on bank accounts. This, ultimately, will 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.

Though a number of financial technology companies aim to lower costs and automate delivery of financial services, 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 costs and licensure costs are disproportionately burdensome 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, Truth in Lending Act, Fair Debt Collection Practices Act, Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation 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 had higher rates of new business formation after this deregulation."

Concerns about deregulation re-emerged in the aftermath of the 2007-2008 Financial Crisis. Whether increased scrutiny or regulation on financial services providers creates unwanted barriers to entry is a subject of much debate.

Article Sources
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  1. Journal of Banking & Finance. "Banking Deregulation: Allocational Consequences of Relaxing Entry Barriers."

  2. Federal Reserve Bank of St. Louis Review. "The Real Effects of U.S. Banking Deregulation," Page 111.

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