In a recent Economist debate, Franklin Allen and I discussed the relationship  between competition and stability. In the debate I argued that it is not so much the degree of competition in the banking market but rather bank regulation and supervision that drives bank fragility. In a recent paper  with Olivier de Jonghe and Glenn Schepens, we now combine these two areas and test whether the regulatory and supervisory framework influences the competition-stability relationship. And we indeed find several dimensions of the market, regulatory and institutional framework that influences the degree to which competition harms or helps bank fragility.
But let us first review what theory tells us about the competition-stability link, and then examine how this relationship might vary with certain country features. On the one hand, the "charter value" view of banking sees banks as choosing the risk of their asset portfolio. In a more competitive environment with more pressure on profits, banks have higher incentives to take more excessive risks, resulting in higher fragility (e.g., Keeley, 1990). On the other hand, John Boyd and Gianni de Nicoló (2005) have shown that lower lending rates reduce the entrepreneurs ' cost of borrowing and increase the success rate of entrepreneurs' investments. In addition, these entrepreneurs will refrain from excessive risk-taking to protect their increased franchise value. As a consequence, banks will face lower credit risk on their loan portfolio in more competitive markets, which should lead to increased banking sector stability. Empirical studies for specific countries—many if not most for the U.S.—have not come to a firm conclusion for either a stability-enhancing or a stability-undermining role of competition. The cross-country literature has found that both more concentrated and more competitive banking systems are less likely to suffer systemic banking crises, as reviewed by Asli in this column .
How might this competition-stability relationship vary by country? First, certain types of regulation may limit the extent to which banks can or will engage in riskier activities if their charter values are eroded. For example, regulatory capital requirements should limit the extent to which banks can follow risk-taking incentives if banks' charter value is eroded. If so then higher capital requirements might reduce the strength of the competition-fragility relationship. Second, country-specific characteristics may also affect the adverse selection problem that banks face if they charge higher loan rates. For example, credit registries may reduce the likelihood that entrepreneurs will chose riskier project in response to higher loan rates. This would thus influence the strength of the competition-stability relationship. Third, institutional characteristics may affect the proportion of systematic and idiosyncratic risk in loan defaults and may therefore make it more likely that the empirical data favor one theory over the other. For example, regulatory constraints on diversification may make it more likely that loan defaults are highly correlated and hence lead to the empirical outcome that competition is good for financial stability. The relative strength of each of these three channels may explain why previous studies have obtained different results in terms of magnitude or even sign.
Using bank-level data for 79 countries and over the period 1994 to 2009, we find, on average, a positive relationship between market power, as measured by the Lerner index, and stability, as measured by the Z-score. But there is a large cross-country variation in this relationship, as shown in Figure 1. Here, we show the coefficient on the Lerner index in a regression of the Z-score controlling for year effects and bank-level controls and find cross-country heterogeneity, from a negative and significant relationship to a coefficient estimate of almost six. A quick look at the country labels on the X-axis also reveals that it is not just a developed versus developing countries story or that geographical regions exhibit similar behavior.
Figure 1: Conditional correlation of bank market power and stability
(Click the image to view a larger version)
When relating this variation in the conditional relationship between banks’ market power and stability across countries and over time, we find several significant results:
- In countries with more effective systems of credit information sharing and more developed capital markets, the impact of market power on bank fragility is more muted. More effective systems of credit information sharing between financial institutions reduce the effect of higher interest rates on borrowers’ risk taking. Similarly, better developed capital markets constitute competition to banking systems and can result in more information disclosure and transparency, thus again dampening the effect of higher interest rates on fragility. Conversely, this also suggests that the negative effects of competition on stability are less strong in these countries.
- In countries, with more generous deposit insurance schemes, the impact of competition on fragility is exacerbated. More generous deposit insurance schemes thus increase risk-taking incentives in more competitive environments. Similarly, we find evidence that more stringent capital requirements do not dampen the competition-fragility relationship, but rather might even strengthen it, contrary to what theory suggests and policy makers pushing for higher capital requirements hope for. We also find that distressed banks are more likely to take aggressive risk in more competitive environments, thus evidence for a betting-the-bank behavior.
- The impact of competition on fragility is stronger in countries with stronger Glass-Steagall type activity restrictions and more homogenous banking systems. As competition increases, a stronger tendency towards herding, caused either by regulatory restrictions or by homogeneity in banks’ revenue models, will thus exacerbate fragility in such countries.
These findings are not only statistically, but also economically relevant. To illustrate the policy relevance of these findings, we applied recent policy changes and reform suggestions to our estimates. In the midst of the crisis, many countries increased the generosity of their deposit insurance schemes. At the same time, there were calls for restrictions on banks' activities, as previously existed under the Glass-Steagall Act in the U.S. Mimicking this post-crisis scenario for a fictitious ceteris paribus analysis reveals that the relationship between market power and soundness is almost twice as strong compared to the benchmark case, suggesting a very negative impact of competition on stability in this scenario. In the base scenario, a one standard deviation reduction in market power leads to a drop in the Z-score of 20%. In our fictitious post-crisis scenario with more generous deposit insurance, increased activity restrictions on banks and more revenue herding, a similar loss in market power leads to a 38% reduction in the average Z-score, i.e. the buffer of capital against losses expressed in terms of profit volatility. In a nutshell, the regulatory changes implemented in many countries after the recent crisis have strengthened the competition-fragility relationship, leading to an increased risk of financial instability in countries where markets remain competitive.
Boyd, J. H., and G. De Nicolo, 2005, The Theory of Bank Risk Taking and Competition Revisited, Journal of Finance 60(3), 1329.1343.
Keeley, M. C., 1990, Deposit Insurance, Risk, and Market Power in Banking, American Economic Review 80(5), 1183.1200.