By Ronald Fischer*
Excessive competition may put the banking system at risk?
This does not appear so obvious to economists.
For example, the 2013 Global Financial Development Report highlights that ‘competition in the banking sector promotes efficiency and financial inclusion, without necessarily undermining financial stability’.1
Other economists believe there is theoretical and empirical support for the existence of a tradeoff between competition and stability in the banking system.2
As circumstantial support for the existence of this tradeoff, consider the case of Canada. It is supposed to have the safest banking system in the world.
Five banks dominate the market, with 85% of total assets and profits of US$ 26.59 billion in 2012 (1.5% of GDP).
New Zealand is another country in which banks are very solid and very concentrated. In 2012, its five major banks made profits of US$2.86 billion (1.9% of GDP) and held more than 95% of all bank assets.3
Note that New Zealand banks’ credit ratings are in the A+ to AA-category, and some of them are included among 50 safest banks worldwide (2012 rankings).
Similarly Chile, whose five major banks hold 73% of all banking assets, saw banks making profits of US$ 3.35 billion in 2012 (1.2% of Chile’s GDP).4 The major Chilean banks are also very safe.
The four highest Latin American bank ratings are Chilean and two of them are among 2012’s 50 safest banks in the world.
In these three countries, banks resisted the financial crisis of 2008 and had only minor downgrades in their credit ratings.
A relationship that has been explored by empirical researchers, but not often by theorists, is the link between banking competition and economic instability.
They have found that economic depressions follow a banking crisis when the regulatory system is inadequate. A case in point was Chile, where financial liberalisation (and the concomitant increased competition) led to a systemic crisis within the banking system in 1982 and a subsequent depression, with GDP growth rates of -14.3% in 1982 and -3.5% in 1983.
That crisis led to the creation of a strong banking regulator, who restricted entry into the banking sector for more than a decade and created a strong banking sector with little competition.
Show me the links
Many researchers have studied the possible existence of a link between competition and stability in the banking sector. Leaving aside the possibility of runs due to sunspots,5 theoretical researchers have found contradictory results.
By focusing on the demand for loans, the authors of one paper6 reason that, when markets are less competitive, interest rates rise and thus only firms that have risky projects find these rates attractive. Hence more competition would lead to safer lending and a smaller risk of banking instability.
A complementary argument7 notes that when there is intense competition, spreads are low (so lending is not very profitable) and the opportunity cost of reserves is low.
Thus banks can afford large reserves, leading to greater safety for depositors.
Other researchers8 observe that banks choose the riskiness of their loan book.
When rates are low, they attempt to increase their returns by lending to riskier projects. According to this line of reasoning, an increase in the intensity of competition would increase the systemic instability of the banking sector.
The empirical evidence is also ambiguous. For example, a paper9 that examined the effects of the 1980s deregulation process in the US banking industry found that risk-taking increased, leading to more instability in the banking sector. A more recent examination of increased competition in Spain10 obtained similar results.
However, various studies that use cross-country data11 find evidence that competition leads to more stable banking industries.
A very recent cross-section study12 tries to reconcile the conflicting evidence of single-country and cross-country studies. By including a measure of the quality of banking regulation, as well as variables corresponding to other financial-market characteristics of the countries, this study shows that it’s possible to find a positive association between competition and banking-system instability.
Wait … there’s more
In a recent paper,13 I and my colleagues developed a theoretical model that links banking competition to instability in the banking sector and hence to the economy more generally.
The model tries to reproduce the stylised facts of the industry and we assume the possibility of an initial shock to the real economy (an example would be the EMS syndrome currently affecting the shrimp industry in Thailand, or the ISA virus that almost destroyed the Chilean salmon industry in 2008- 2009).
The losses due to the initial shock imply that firms in the sector, although they may still be viable, cannot repay their working capital loans. Banks that lent to these firms may end up with less capital and reserves after repaying their short-term obligations.
If the size of the initial shock is sufficiently large, the reduction in capital and reserves leads to a reduction in the bank’s loans, because they are constrained by capital adequacy restrictions.
Since these capital adequacy restrictions allow a bank to lend a multiple of its capital and reserves, lending is reduced by a multiple of the initial defaults. Thus banks amplify the economic effect of the initial shock.
What is the effect of competition? Since competition reduces the interest rate spread and the cost of loans, there is more lending and economic activity initially.
Banks become more highly leveraged (or geared): that is, their lending is closer to the capital adequacy limit. Thus the amplification effect of the initial shock will be larger.
This explains the relationship between economic instability and the intensity of competition, and shows the existence of a tradeoff between the benefits of competition and increased economic instability.
The paper models this intuitive argument using a twoperiod model and provides additional results. First, the model allows for two types of equilibria in a banking system: a prudent equilibrium, in which the banks restrain their lending so that they can survive the shock; and an imprudent equilibrium, in which the controllers of banks bet that the shock will not occur.
In the latter case, they choose to lend more than in the prudent equilibrium. Banks are very profitable when there is no shock, but fail if the shock occurs and need to be rescued by the public (a case of privatisation of profits and socialisation of losses).
This type of equilibrium may appear when capital adequacy restrictions are loose, so banks can lend a high multiple of their capital and reserves.
Our model shows that as competition increases, the attractiveness of the imprudent equilibria increases.
So the combination of competition, loose regulation and deposit insurance can be lethal for the banking system.
Prudential regulation (for example, stringent capital adequacy regulations such as those Switzerland has imposed on its major banks) rule out the possibility of imprudent equilibria.
The model explains another feature of the banking sector: the role of regulatory forbearance.
In a financial crisis (such as the Global Financial Crisis of 2008), the banking regulator will usually relax its capital adequacy restrictions in the hope of dampening the effect of the crisis on economic activity. Our model shows that so long as forbearance is unexpected, it can reduce or eliminate the impact of the financial crisis on economic activity.
However, it also shows that if banks anticipate regulatory forbearance in case of a shock then they will increase their preshock lending, which at least counteracts the effects of forbearance and potentially leads to increased instability.
Banking competition produces a tradeoff between the benefits of economic stability and increased economic efficiency.
Choosing the optimal intensity of competition is a difficult task for a regulator. In general, a strong banking regulator will tend to be cautious and restrain banking competition by too much.
-------------------------------------------------------------------------
1 The World Bank (2013) Global Financial Development Report Chapter 3 (available at: http://econ.worldbank.org/WBSITE/ EXTERNAL/EXTDEC/ EXTGLOBALFINREPORT/0,,contentM DK:23267294~pagePK:64168182~piPK:64168060~theSite PK:8816097,00.html).
2 X Vives (2010) ‘Competition and stability in banking’ IESE Business School University of Navarra Working Paper 852 April.
3 http://research.stlouisfed.org/fred2/series/DDOI06NZA 156NWDB
4 A Cunningham (2012) ‘Awards: World’s Safest Banks 2012’ Global Finance (available at www.gfmag.com/archives/160- october-2012/12014-awards-worlds-safest-banks-2012. html#axzz2htOioTis).
5 As in the seminal paper of DW Diamond and PH Dybvig (1983) ‘Bank runs, deposit insurance, and liquidity’ Journal of Political Economy 91(3) pp401–419.
6 JH Boyd & G De Nicoló (2005) ‘The theory of bank risk taking and competition revisited’ Journal of Finance 60(3) pp1329–1343.
7 E Carletti & A Leonello (2012) ‘Credit market competition and liquidity crises’ EUI (European University Institute) Working Paper 14 April.
8 F Allen & D Gale (2004) ‘Competition and financial stability’ Journal of Money, Credit and Banking 36(3) pp453–479.
9 The 1980s US deregulation allowed banks to enter markets away from their home states, thus raising the intensity of competition in the industry. See: FR Edwards & FS Mishkin (1995) ‘The decline of traditional banking: Implications for financial stability and regulatory policy’ NBER (National Bureau of Economic Research) Working Paper 4993 August.
10 J Saurina-Salas, G Jimenez & JA Lopez (2007) ‘How does competition impact bank risk taking?’ Federal Reserve Bank of San Francisco Working Paper 23 February.
11 For example: K Schaeck, M Cihak & S Wolfe (2009) ‘Are competitive banking systems more stable?’ Journal of Money, Credit and Banking 41(4) pp711–734; D Anginer, A Demirguc-Kunt & M Zhu (2012) ‘ How does bank competition affect systemic stability?’ World Bank Development Research Group Working Paper 5981 February.
12 T Beck, O De Jonghe & G Schepens (2013) ‘ Bank competition and stability: Cross-country heterogeneity’ Journal of Financial Intermediation 22(2) pp218 – 244.
13 R Fischer, N Inostroza & F Ramirez (2013) ‘Banking competition and economic stability’ CEA (Centre for Applied Economics) Working paper 297 June (available at http://papers.ssrn. com/sol3/papers.cfm?abstract_id=2277246).
-------------------------------------------------------------------------
Ronald Fischer is a professor at the Centre of Applied Economics at the University of Chile. He visited ISCR in August 2013 and led a teaching workshop around the subject of public-private partnerships. The author would like to acknowledge support from the Instituto de Sistemas Complejos de Ingeniería in the preparation of this article.
This article was first published in Competition & Regulation Times, and is used here with permission.
We welcome your comments below. If you are not already registered, please register to comment.
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.