Competition versus efficiency: What drives franchise values in European banking?

This paper investigates how stock market investors perceive the impact of market Structure and efficiency oil the long-run performance potential of European banks. To that end, a modified Tobin's Q ratio is introduced Lis a measure of bank franchise value. This measure is applied to discriminate between the market structure and efficient-structure hypotheses in a coherent forward-looking framework, in which differences in banks' horizontal and vertical differentiation strategies are controlled for. The results show that banks with better management or production technologies possess it long-run competitive advantage. In addition, bank market concentration does not affect all banks equally. Only the banks with a large market share in a concentrated market are able to generate non-competitive re,its. The paper further documents that the forward-looking. long-run perspective and the noise-adjustment of the performance measure overcome most of the drawbacks associated with testing these hypotheses in a multi-country Set-Up. Finally. notwithstanding the international expansion of bank activities. the harmonization of regulation and the macroeconomic convergence in the European Union (EU 15), we still find that country-specific macroeconomic variables have a significant impact on bank performance. The findings indicate that there is a trade-off between competition and stability that Should be taken into account when assessing mergers or acquisitions. (C) 2007 Elsevier B.V. All rights reserved.