Syndicate content

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. 

Bailing Out the Banks: Reconciling Stability and Competition in Europe

Thorsten Beck's picture

The relationship between market structure, competition and stability in banking has been a policy-relevant but controversial one (see Beck, 2008 for a pre-crisis survey).  The current crisis has put the topic back on the front-burner, and particularly so in Europe, where competition concerns about the effect of national bail-out packages on competition across Europe rank high.  Together with four other European economists, I have tackled this question in a recent CEPR report: Bailing out the Banks: Reconciling Stability and Competition.

The crisis has provoked two common but quite different reactions concerning the role of competition policy in the banking sector.  One reaction has been to jump to the conclusion that financial stability should take priority over all other concerns and that therefore the "business as usual" preoccupations of competition regulators should be put on hold.  Another reaction has been to fear that intervention to restore financial stability will lead to massive distortions of competition in the banking sector, and therefore to conclude that competition rules should be applied even more vigorously than usual, with the receipt of State aid being considered presumptive grounds for suspecting the bank in question of anti-competitive behavior.  We endorse neither of these points of view. 

Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.


In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

What Do We Know about the Consequences of Foreign Bank Participation in Developing Countries?

Maria Soledad Martinez Peria's picture

The process of financial globalization that accelerated in the 1990s has brought many changes to the financial sectors of developing countries.*  Countries have opened up their stock markets to foreign investors, allowed domestic firms to cross-list and issue debt overseas, and welcomed foreign direct investment into their local financial sectors.  When it comes to the banking sector, arguably no change has been as transformative as the increase in foreign bank participation in developing countries.  On average, across developing countries, the share of bank assets held by foreign banks has risen from 22 percent in 1996 to 39 in 2005.  At the same time, foreign bank claims on developing countries, which together with the loans extended by foreign bank branches and subsidiaries include cross-border loans, increased from 10 percent of GDP in 1996 to 26 percent in 2008 (see Figure 1).

Total foreign claims

What Explains Firm Innovation in Developing Countries?

Asli Demirgüç-Kunt's picture

Many economists agree that innovation is essential for economic growth.  But the little we know about firm innovation is based on the study of large, publicly-traded firms in developed countries.  As Moisés Naím, editor-in-chief of Foreign Policy magazine, pointed out at the recent Financial and Private Sector Development Forum, large, publicly-traded firms have served as the basis for a lot of formal economic analysis, but they are much less typical of developing countries.  This is a problem, since we know from existing studies that small and medium size firms play an important role in developing countries.

What might explain the likelihood of these firms to innovate?   Here are some of the key issues that deserve closer scrutiny:

  • Are certain types of firms more innovative than others?
  • What is the role of finance, governance and competition?
  • Is ownership or corporate form important?
  • Does foreign competition or trade openness matter?
  • And what about the education and experience of managers and workers?

How Do Firms Finance Investment?

Asli Demirgüç-Kunt's picture

A large body of literature has found that in countries with weak institutions firms are able to obtain less external financing, resulting in lower growth.  Indeed, even simple cross-country comparisons of firm financing patterns can be quite revealing.  In a paper co-authored with Thorsten Beck and Vojislav Maksimovic, this is exactly what we do.  Using data from the World Bank’s Enterprise Surveys dataset (WBES) for 48 countries, we investigate what proportion of firm investment is financed externally, and, of this external finance, how much of it comes from different sources, such as bank and equity finance, leasing, supplier credit, development banks, and informal sources such as money lenders.

In our sample of firms, on average just over 40 percent of firm investment is externally financed.  Breaking external financing down into its parts, about 19 percent of all financing comes from commercial banks and 3 percent from development banks.  Another 7 percent is provided by suppliers and 6 percent through equity investment.  Leasing is another 3 percent, and less than 2 percent comes from informal sources.  More recent enterprise survey data for an expanded sample of countries and firms also suggest similar patterns (Figure 1).

Source: Enterprise Surveys, covering 71 countries

What Does the Financial Crisis Teach Us about the Feasibility of Different Banking Models?

Asli Demirgüç-Kunt's picture

The recent financial crisis has seen the demise of large investment banks in the U.S.  This major change in the financial landscape has also rekindled interest in discussion of optimal banking models.  All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities.  Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?

To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis.  However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net.  So which model is more desirable?

Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution.  On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers.  Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance.  This argues for the merits of universal banks.

On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank.  So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance.  This tends to support the separation of commercial and investment activities. 

Measuring Access to Finance…One Step at a Time

Asli Demirgüç-Kunt's picture

How well do financial systems in different countries serve households and enterprises?  Who has access to which financial services – such as savings, loans, payments, insurance?  Just how limited is access?

Just a short while ago, we didn’t know the answer to these questions.  But modern development theories very much emphasize that broad financial access is the key to development.  Lack of access to finance is often the critical element underlying persistent income inequality as well as slower growth.  Without inclusive financial systems, poor individuals and small enterprises need to rely on their personal wealth or internal resources to invest in their education, become entrepreneurs, and make their businesses grow.  So it was disappointing that although data on the financial sector have been readily available, data on access simply were not.

Those of us who spend our days trying to find ways of influencing policy decisions know that one of the most effective ways of focusing policy attention on an issue is by measurement.  If you can measure something and “benchmark” it with useful comparisons, you are one step closer to identifying what needs to be done.  And if you can provide these measurements at regular intervals, you are more likely to capture the attention of policymakers, promote policy change, and track and evaluate the impact of such policies. A team at the World Bank began thinking about this issue in the beginning of this decade, so when the UN announced 2005 as the Year of Microcredit, we were more than ready to rise to the challenge. 

Microfinance: Dream vs. Reality

Asli Demirgüç-Kunt's picture

Microfinance started as a simple idea: to provide loans to poor entrepreneurs.  Today it is a much more diverse and dynamic sector, and includes institutions that provide savings and remittance services, sell insurance, and offer loans for a wide range of purposes.  The idea now is to focus on bringing a range of financial services to the underserved.  The institutions that focus on this mission vary in the income levels of the customers they serve, their use of subsidies, and the breadth and quality of services offered.  This diversity also presents microfinance providers new opportunities as well as trade-offs.

When Muhammad Yunus and Grameen Bank won the Nobel Peace Prize in 2006, the world community celebrated the ways that expanding financial access can improve the lives of the poor.  Many microfinance “insiders” have been working toward a second goal as well: to find ways to provide microfinance on a commercial basis, without long-term subsidies.  The argument that microfinance institutions should seek profits has an appealing “win-win” resonance, admitting little trade-off between social and commercial objectives.  Should institutions move up-market to provide larger loans and improve financial performance?  Is deposit-taking feasible at such scales?  Can socially-minded institutions survive commercial competition and regulation without re-defining their mission?