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.
What can policymakers take away from this? While competition in the financial sector can lead to financial fragility in a weak institutional framework, it is important to focus on improving this framework, rather than limiting competition. There are certainly ways to minimize potential trade-offs between competition and stability, such as putting in place appropriate risk management tools as well as setting up strong supervisory and regulatory frameworks. If anything, the recent crisis highlighted the relevance of sound legal and institutional arrangements for countries to minimize moral hazard concerns related to increased financial competition and/or financial liberalization episodes.
In addition to improving the institutional framework, policymakers may also want to focus on the environment for small banks. Conventional wisdom holds that as long as the market is contestable (with clear and transparent entry and exit policies), the level of concentration is a minor issue. But there are some questions when it comes to impact on access. Several studies show a positive correlation between bank size and market power, with smaller banks tending to operate primarily in local markets where competition is often seen as weaker. As a corollary, larger banks tend to operate on national and international levels where competition is generally assumed to be stronger. Weak institutional environments also limit the ability of large and foreign banks to serve smaller businesses through the use of technologies that are based on quantitative data, increasing the relative importance of soft-information-based relationship banking—the kind that smaller banks are better at. Hence, while more research remains to be done on this topic, in weak institutional environments, the existence (and entry) of prudently operated small banks may improve domestic competition and access.
Overall, to improve competition without undermining financial stability, policymakers ought to focus on fostering the appropriate incentive framework. These incentives will be shaped by the design of entry and exit policies and prudential regulations and supervision. In the face of a crisis, the manner in which prompt corrective action and bank resolution and restructuring arrangements are applied can help minimize potential moral hazard problems and avoid excessive risk-taking as well as minimize fiscal costs to the taxpayers. The regulatory framework also needs to strike the right balance between curbing excesses while avoiding potential anti-competitive effects. For example, better disclosure, prudent (but not excessive) capital requirements for entry as well as operation, and greater transparency in pricing are the types of actions that would improve supervision without impairing competition. In contrast, increases in regulatory costs that raise entry barriers into the financial sector make markets less contestable, depriving countries of many of the benefits of an efficient and innovative banking system.
Beck, Thorsten, Asli Demirguc-Kunt and Ross Levine, “Bank Concentration, Competition, and Crises: First Results ,” Journal of Banking and Finance, Vol 30(5) May 2006, pp1581-1603.
Beck, Thorsten, Asli Demirguc-Kunt and Ross Levine, “Bank Concentration and Fragility: Impact and Mechanics ,” in The Risks of Financial Institutions, edited by Rene Stulz and Mark Carey, National Bureau of Economic Research, 2006.
Berger, Allen, Asli Demirguc-Kunt, Ross Levine and Joseph Haubrich, “Bank Concentration and Competition: An Evolution in the Making ,” Journal of Money, Credit and Banking, Vol. 36 (3), 2004.