Bank Competition and Financial Stability - Research Paper Example

Bank Competition and Financial Stability Concerns regarding the stability of the banking sector are often a centre point for policy debates. Starting from the time after the World War II till the 1970’s, the world saw a stable period. However, early 21st century started off with a period of banking system instability, linked to the U.S. subprime lending crisis. Competition is considered as a pre requisite for an effective system of banking. Theoretical and Empirical findings have rendered such propositions false. The past decade has also witnessed the consolidation of the banking systems around the world. Cross border mergers and entry of foreign banks into the developing countries have been consistent. Consolidation leads to efficiency and scale economy arguments, but accompanying it rises debates regarding the stability (Cooper, 2008). Economic Theory comes up with ambiguous results about the structure of the market and the competitiveness and stability of the banking sector. Empirical findings also provide similar ambiguous results (Beck, 2008, pp 1). There are basically two thoughts relevant in identifying the relation between financial stability and bank competition. One, the completion fragility view infers that any competition within the market will result in lowering of the profits for the firms since competition decreases market power. Two, the competition stability view infers that as the banks become more powerful in the loan market, they keep taking higher risks (Allen & Gale, 2004). This paper will therefore offer a critical insight into understanding the key variables of the relationship between financial stability and bank competition. Stability and Competition Detragiache defines banking distress as when nonperforming assets reach a significantly large percent of total assets, emergency measures are taken to assist the banking system and large scale bank nationalizations take place. Honohan and Laeven tell how the financial crisis have spread all over the globe where both big and small countries have been hit. Failures of large international banks, which have branches in the small countries, have affected the developing economies as well. Bank stability has been measured in terms of levels or closeness to bankruptcy. Researchers usually use the Z-score which is measured by the sum of capital asset ratio and the return on assets weighted by the standard deviation of return of assets (Beck, 2008, pp 4). Another measure has been the non-performing loan ratio as an indicator of fragility. Both exclude actual bank failures. Bank competition measures include market structure measures such as Herfindahl indices and concentration ratios which are crude measures. Next, there is H-statistic which measures the reaction of input to output prices. Lastly, Regulatory framework indicators such as entry requirements, barriers and other restrictions allow indications competition (Beck, 2008, Pp 6, 7). Theoretical predictions Theoretical models have reported contrasting predictions on the bank stability and concentration. Most theoretical models avoid making distinctions between concentration and competition and resort to one to one mapping from market structure to competitive behavior of the banks. Under this we have two hypotheses. Competition-Fragility Hypothesis: Certain models infer that less competitive banking structures are more stable and fragility is prevented by the buffer generated by the profits. It also creates opportunities for additional risk undertaking (Beck, 2008, pp 7-8). In a competitive scenario with profits getting squeezed, banks take to more risk undertaking resulting in greater fragility. On the other hand, under limited competition banks have greater profit opportunities and do not resort to additional risks (Allen and Gale 2000, 2004). Another scenario where competition can impact stability is the interbank market and payment system. Perfect competition prevents banks from providing liquidity to banks hit by temporary shortages. If all the banks resort to price taking then no bank has the will to supply liquidity to the troubled banks resulting in the troubled bank being shut down with negative repercussions (Allen and Gale 2000). Regulatory policies such as a lessening of the charter value and generous deposit insurance can undermine bank stability in a multiple manner. Matutes and Vives shows that deposit insurance schemes can steer clear from a confidence crisis and can adjust the coordination failure in multiple model equilibriums. However, in a parallel way, deposit insurance schemes can provoke detrimental rivalry between banks, decrease payback from diversification and bring about an increase in the likelihood of breakdown. Perrotti and Suarez, show that policies that suggest mergers of the weak banks with the healthy banks, lead to an increase in risk undertaking. An active entry policy reduces negative effects of completion. Competition Stability Hypothesis: While the Charter value hypothesis assumes that less competitive systems are more stable, an opposite view is that a more concentrated system of banking leads to greater fragility (Beck, 2008, pp 9-10). Boyd and De Nicolo confirm that concentrated system of banking will increase the market power and allows the banks to increase the rate of interest they charge to the firms. Firms thus taker greater risks and there might be a possibility of the loans turning non-performing. Boyd and Nicolo thus find an affirmative result in bank concentration and fragility (Berger, Klapper, & Turk-Arsis 2009). Also, this view suggests that fewer banks come under concentrated banking. These banks also receive more subsidies that intensify risk taking and increase the fragility along with the risk of contagion. Supporters of this view would not agree that in a concentrated system, represented by fewer banks, is easier to monitor. Larger banks are harder to monitor with the variety of services they offer. The recent consolidation has led to further specializations and thus present a positive relation between concentration and fragility. Empirical Findings Recent literature is consistent with a competition stability view. Boyd and Nicolo put forward that more market power in the loan market leads to higher risk, riskier set of borrowers due to adverse selection considerations. Also highly concentrated banking market leads to the institutions taking more risks in belief that they are too big to fail. Recent empirical work is consistent with this view. Boyd, De Nicolo, and Jalal and De Nicolo and Loukoianova found that an inverse measure of bank risk, the Z-index, gets lowered with banking market concentration, suggesting an increase in the risk of bank failures. Recent empirical cross-country findings have shows an ambiguous relationship between bank concentration and bank competition. We take a recent empirical analysis for our study. Here data from 23 industrialized countries, firm level data from banks have been used to test the implication of market structure on risk potential on banks. Data from 1999-2005 have been used. Banks with missing loan to asset ratios and income statement data are omitted from the group (Berger, Klapper, Turk-Ariss 2008, pp 10). Financial stability is the dependent variable, and the independent variables being market structure and business environment. Different risk exposure indicators have been used such as the Z-index and NPLs (non performing loans). Berger, Klapper, Turk-Ariss, (2008) analyze the impact of market structure in banking and financial stability using the Lerner index as a proxy for market power. Also more market power in developed countries leads to loan portfolios being riskier, but overall bank risks is reduced in large as they hold significantly more equity capital. This shows that banks with more power are subjected to lesser risks. Secondly, foreign ownership leads to greater bank fragility, as reported by the Z-index. Thirdly, there is also proof that strong legal rights are related to lower capitalization levels (Berger, Klapper, Turk-Ariss, 2008, pp 11-15). A recent Financial Stability report of the UK, June 2011 presents some interesting facts about financial stability (Financial Stability Report, June 2011, pp 6-19) Risks from international Financial System remain high for the banks in UK. Markets, including those in Europe had faced adverse shocks with Greece, Ireland and Portugal leading the list of credit defaulters. Major political unrest in North Africa and the Middle East have led to higher oil prices, along with a tsunami and earthquake leading to lower sovereign rating. Even after all this, December 2010 reports suggested that financial markets had held on firmly helped by minor improvements in the global economy. This had led to capital redistribution in the financial system globally. However the demand from emerging economies of the US economy debt remains strong. According to the report, developments in global financial markets have implications for the UK banks. The following risks were present to the UK banks. 1) Sudden reversal of low bond yields or an increase in the volatility of the market. 2) Abrupt change in asset valuation due to rising risk. 3) Unstable funding. Increased liquidity was crucial for checking the global financial crisis. Low bond yields remain open to reversals affecting banks directly and could lead to a bad impact on global markets. Risk taking can be increased due to low interest rates. Leverage can always amplify the shocks. Financial engineering have led to complex financial products, including the amount of information and advanced modeling techniques. Incorrect assessment of these can lead to ‘Risk Illusion’. Both complexity and connected nature surpass investors understanding power resulting in opacity of financial instruments. Monitoring the evolution of markets or exchange traded funds can show that technology invented to help manage risk can sometimes be a cause for even more risk. Banks are always exposed to liquidity related risks. Although the global markets have recovered a lot, still fiscal positions are fragile and a threat of another recession looms large. Conclusion: From the competition fragility view, it can thus be concluded that, greater bank competition will usher away market power, profits will decrease and cause reduced franchise value, which in turn encourages banks to take more risks. Under the competition stability view, more power to the loan market leads to higher bank risk, which further leads to moral hazards and adverse selections. Our show, that according to the competition fragility view, banks with higher market power have less risk undertaking. However, from competition stability view, the market power increases riskier loans (Berger, Klapper, Turk-Ariss, 2008, pp 16). References Allen, F., & Gale, D. (2004). Competition and Financial Stability. Journal of Money, Credit, and Banking, 36(3), 453-480. Beck, T. (2008), Bank competition and Financial Stability: Friends or Foes? , The World Bank, 4656, retrieved on October 14, 2011 from: http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2008/06/26/000158349_20080626083219/Rendered/PDF/wps4656.pdf Berger, A. N., Klapper, L. F., & Turk-Arsis, R. (2009). Bank Competition and Financial Stability. Journal of Financial Services Research, 35(2), 99-118. Boyd, J H., De Nicolo,G ., and Jalal, A(2006), Bank Risk taking and competition: New Theory, new empirics. IMF Working Paper 06/297. Allen, F., & Gale, D. (2000) Comparing financial systems. Cambridge, MA: MIT Press. Boyd, J H., De Nicolo,G (2005) The theory of bank risk taking and competition revisited. Journal of Finance 60, 1329-343 Berger, A N., Klapper,L ,F.,Turk-Ariss,Rima, (2008),Bank Competition and Financial Stability, Policy Research Working Paper, 4696, pg 1,6-8,10-11,17-19. Cooper, G. (2008 ). The origin of financial crises :central banks, credit bubbles and the efficient market fallacy. New York: Vintage Books. Financial Stability Report, (June 2011), Bank Of England, Issue 29 Read More