Korea Capital Market Institute

1. Market Size and Industry Structure The modern structure-conduct-performance analysis attempts to establish a systemic relationship between industry structure and market size (Sutton 1991). The main questions are (1) whether the market becomes more concentrated as market size grows, and (2) how other dimensions of the product change afterward. These are timely and relevant, particularly for the Korean financial industry, because the capital markets are expected to grow significantly in the next decade. With that in mind, we investigate the changes in competitive behavior in the financial investment industry, more specifically, the securities industry, as market size increases. Firms compete not just on price but also along other product dimensions such as quality. This competition, with increased market size, leads to adjustments in market concentration and segmentation. First, some firms with sufficient resources incur large sunk costs to decrease average costs and/or to improve quality. These firms form an oligopoly of dominant players while many other smaller firms remain as fringe players. Thus, concentration does not necessarily fall. A given industry in different-size markets can remain highly concentrated, but bigger markets tend to have higher-quality products. Second, the profit-maximizing strategy compels large, dominant firms to ration certain customers out. These left-out customers usually turn to smaller, fringe firms and a new niche market appears. Segmented markets also provide ample opportunities for new entrants as they compete only with fringe firms. In this study, we examine the following three questions in more detail. First, does a lower bound on industry concentration exist when the market expands? Second, in the investment banking industry, does increased market size accompany an oligopoly of a few dominant banks differentiated by large sunk costs? Third, does a new niche market emerge as some customer are rationed out, and does this mean more opportunities for new, nimble investment banks? An oligopoly of large investment banks is a prevalent phenomenon in developed countries. Our analysis reveals that market concentration deepens as market size (in terms of IPOs, bond issuance, and M&A activity) expands. The market share of the large, dominant investment banks becomes bigger as the market matures. The customer base for these banks is relatively narrow. As a result, the increased market size brings new entrants into a niche market populated by rationed-out customers, and the share of small banks in the total number of investment banks becomes larger. Our empirical analysis lends credence to the following remarks regarding the Korean financial investment industry. First, after the industry undergoes substantial changes, only a few large investment banks/securities firms emerge as winners. Second, these large, dominant firms will monopolize the market. However, there will be aggressive competition among them for the selected group of consumers. Lastly, most other securities firms choose to remain rather small and serve a niche market. They will specialize in a specific area such as M&A activity or derivatives trading. 2. Market Segmentation The financial investment industry in Korea will experience significant upheaval as the market size increases; only a few firms will survive as dominant players while other firms become smaller, niche players. Then, what implications does market segmentation have for the services provided by the financial investment industry? First, the investment banking service will be monopolized by large, dominant firms. Securities firms need a significant amount of capital to provide investment banking services because the risks in bringing an issuer to the primary market are high. However, when the issuers are medium- and small-sized, there is room for smaller securities firms. To be successful in this part of the financial investment industry, these smaller firms need to provide research-based brokerage services as well as investment banking services. Second, the brokerage service will also be suitable for the large, dominant firms. Economies of scale are critical in providing brokerage services to investors. On the other hand, even the smaller firms can compete in brokerage services for corporate issuers if they accumulate enough research experience in the corresponding industry. Third, in fund sales, the larger, dominant firms have advantages over the smaller firms. For example, the smaller firms lack the sales network that the larger firms can easily establish. Still, the smaller firms might be able to compete if they acquire asset management companies as subsidiaries. Fourth, asset management services will be suitable for large, dominant firms. Asset management requires skilled experts, a large branch network, and large-scale IT infrastructure. Especially, a successful retail asset management service demands considerable fixed costs while corporate asset management services could be profitable without a large branch network. Thus, medium- and small-sized securities firms need to focus on corporate asset management services. Fifth, in the OTC derivative trading, the involved risk and hedging require a large amount of capital. These factors make only large, dominant firms fitting for trading. Even though smaller firms might be able to enter the market when the necessary capital is not considerable, that part of trading tends to be less profitable than others. As a result, large, dominant firms can successfully provide all the services that we have discussed above, while smaller firms have advantages in a limited number of areas. Thus, smaller firms need to utilize their resources to specialize in those services. 3. Asset Management Industry Compared with other developed countries, Korea has only a few asset management companies. This is still true when we compare the number of companies per population across countries. Thus, in Korea, a small number of asset management companies can easily monopolize the industry. Actually, market concentration in the equity funds industry is very high in Korea. High levels of market concentration imply potential welfare loss for consumers. Information asymmetry usually affects individual investors more severely than institutional investors. As a result, individual investors face more welfare loss due to monopolization. Since the ratio of individual investors in the equity funds industry is relatively high in Korea, the welfare loss might be larger than in other developed countries. We also investigated whether market concentration accompanies economies of scale, and we did not find any evidence of economies of scale. In the equity funds industry, we could not find any negative correlation between company size and compensation levels. There is also no positive relationship between company size and fund performance. Therefore, market concentration did not yield any economies of scale effect. The consumer gain would be, if any, minuscule. As with individual fund`s performance, economies of scale effect did not exist. Fund performance did not improve even as fund size grew up, and we did not find any evidence of cost efficiency. This is in contrast to the cases for other developed countries, where cost efficiency routinely appears as fund size increases. 4. The Outlook for Korean Financial Investment Industry Innovation is a critical component for sustaining economic growth, but it involves substantial risk. It is desirable that a small number of large, dominant financial firms play an important role in assisting those innovative companies by venture capital funding. Many other smaller firms need to specialize in a certain service; they will compete with each other, and as a result, niche markets will thrive. In a nutshell, the diversity in Korea`s capital markets should increase significantly. This analysis leads to several policy recommendations regarding financial investment industry. First, there should be some urgency to foster large, dominant securities firms as market leaders. Mergers among firms might be the fastest way to create a super-sized financial firm, but we suspect that currently there are not many incentives for such a merger. In Korea, many securities firms are directly affiliated with industrial capital. Accordingly, these firms focus on providing services to the affiliated companies and lack the incentives for mergers. Other bank-owned securities firms are in a similar situation. This makes voluntary mergers between securities firms difficult, and is likely to protract them even if they happen. We believe that the government may need to step in. Specifically, the government can induce mergers between government-owned securities firms or sell these securities firms strategically to promote the emergence of large, dominant financial firms. Once a few large firms become dominant players in the market, market segmentation is expected to proceed smoothly and quickly. Second, the government needs to be enthusiastic about smaller firms` entry into the industry. We already argued that the capital markets need the diversity for long-term development. And smaller firms specializing in a certain service area are indispensable for diversity. Moreover, the new entries will facilitate the exit of inefficient mid- and small-sized firms as the specialization of services progresses. Third, corporate governance in large financial holding companies needs to change. All the large financial holding companies in Korea have securities firms as a subsidiary. However, most of the directors have worked at banks or bank-related services, and they lack the expertise in dealing with the management of securities firms. Thus, the board of directors should include experts who are well-versed in the financial investment industry. Lastly, regarding the asset management service, the entry barrier should be lowered significantly to create a more competitive environment. Even as firm size grew and the market became concentrated, there is no evidence of increased efficiency. Unlike other services in the financial investment industry, the asset management service seems to need more competitive factors, such as more flexible entry policies. In particular, the government could promote the entry of specialized asset management companies.