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.
We reject the idea that the crisis requires the suspension of normal competition policy rules; in times of crisis they are more important than ever. However, we also believe that the competition rules appropriate to the banking sector are not the same as those that should apply to most other sectors. State-aided banks have a different relation to the rest of the economy than state-aided firms in other sectors, and the rules of state aid policy should reflect these differences. Specifically, bailing out one bank usually implies a positive externality for its competitors, either because it prevents systemic problems, or because these competitors are themselves its creditors, and so are indirectly also bailout recipients.
While it makes sense to try to avoid the unfair advantages that public money would give to such recipients, ‘tying their hands’, for example by preventing them from being ‘price leaders’, seems both hard to enforce and misguided to us: it is much better to make sure that these banks are adequately capitalized and then enforce competition on all players in the market. Moreover, in periods where many banks have received bailouts, there are good reasons to avoid imposing conditions on the receipt of State aid that require generalized balance sheet reductions. A lot of restructuring in the sector will be desirable following the crisis, and there is no reason to prevent acquisitions that are compensated by divestitures and therefore avoid net growth of balance sheets. Forcing banks to divest in the short-term, on the other hand, can lead to renewed downward price spirals in asset markets.
Rather than trying to undo the damage that has been done – which is not only impossible, but might create new damage – we recommend looking to the future and focusing on regulatory reform. These reforms should include the introduction of elements of macro-prudential and countercyclical regulation, proper bank resolution frameworks that provide alternatives to liquidation or bail-outs, and a European-level regulatory authority with the necessary powers and resources to intervene and resolve a large Pan-European bank.
Beck, T. 2008. Competition and Financial Stability: Friends or Foes?  in: Bank Indonesia and Banco de Mexico (Eds.): Competition in the Financial Sector.
Beck, T., D. Coyle, M. Dewatripont, X. Freixas and P. Seabright (2010): Bailing Out the Banks: Reconciling Stability and Competition . CEPR, London.
Beck, T., Demirgüç-Kunt, A., and Levine, R. (2006). Bank concentration, competition, and crises: First results . Journal of Banking and Finance 30, 1581-603.
Carletti, E. (2010): Competition, Concentration and Stability in Banking Sector. European University Institute mimeo.