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Bank Concentration, Competition and Financial Stability: What Are the Trade-offs?

Asli Demirgüç-Kunt's picture

Competition in the financial sector has a long list of obvious benefits: greater efficiency in the production of financial services, higher quality financial products, and more innovation.  When financial systems become more open and contestable, we generally see greater product differentiation, a lowering of the cost of financial intermediation, and more access to financial services.  But when we turn to the issue of financial stability, it is no longer so obvious whether competition is beneficial or not.  Is there a trade-off between increased competition and financial sector stability?

In one camp, there are some who stress the notion of charter value—the proposition that the financial sector is unlike other sectors of the economy and that too much competition may be harmful because it reduces margins and may foster excessive risk taking.  In a second camp are those who argue that a more concentrated banking system may exacerbate banking fragility.  This view holds that less competition leads to greater concentration and increased market power, with banks charging higher interest rates and obliging firms to assume greater risks.  Those in the second camp might also point to the recent crisis, arguing that if banks become “too big to fail” the implicit guarantees provided to them can distort their risk-taking incentives, leading to significantly higher fragility.

As usual, theory is conflicted, so we must turn to empirical evidence to help sort out these claims. In fact a substantial amount of empirical evidence supports the idea that competition per se is not detrimental to financial stability when adequate institutional frameworks are in place.  For example, using data for 69 developed and developing countries Thorsten Beck, Ross Levine and I study the impact of bank concentration and regulatory environment on a country’s likelihood of suffering a systemic banking crisis.  In short, we find that concentration makes banking systems more stable. At the same time, we find that the more competitive financial systems—those with lower barriers to bank entry, fewer restrictions on bank activities, greater economic freedoms and higher quality of regulations—tend to be more stable.  Hence, concentrated banking systems are not necessarily uncompetitive.