Competition and Financial Stability - Essay Example

? Competition and Financial Stability COMPETITION AND FINANCIAL STABILITY Introduction There has been debate recently regarding the relationship between competition in banking and the stability, overall, in the financial system. As a result, there are two views in opposition that have emerged. The view of competition fragility makes the argument on a negative relationship between financial stability and bank competition while the view of competition stability makes a positive relationship argument (Boyd et al., 2009: 4). Many studies have tested the relationship in different regions and nations and have come up with contrasting results. It has been argued that, similarly to other industries in the non-banking sector, competition prevalent in the banking sector is desirable because it tends to generate a market that is more efficient, as well as the benefits that tag along like efficient resource allocation and better consumer prices. However, other theories argue more competition in the banking sector may precipitate an increase in instability with regards to the financial systems. Since greater competition in the banking sector leads to a decrease in margins of bank profits, banks are banks are encouraged to acquire riskier investment so as to boost profit levels, which is in support of the competition fragility view (Boyd et al., 2009: 4). However, other arguments make the argument that greater concentration of banks in the loan markets may lead to an increase in instability via increased risks, especially because higher rates of interest that are charged on consumers could make it more difficult for them to pay back the loans, which supports the view on competition stability. Therefore, it is interesting when these hypotheses are tested to decide whether completion in the banking sector is desirable with an aim to increase financial stability (Boyd et al., 2009: 5). In addition, it is interesting to test the relationships in the EU banking industry that experienced a period that saw consolidation of banks and a reduction of competition. At the same time, it has been irrepressible in the center of the global financial crisis. Banking as a Unique Industry Financial and banking markets display the entire array of classical failures of the market because of asymmetric information like adverse selection, moral hazard, and excessive taking of risks with agency problems, externalities like fragility because contagion and coordination problems, and potential power of the markets (Koskela & Stenbacka, 2000: 1857). This has led to regulation that seeks to protect the small investors, the system, and market competitiveness. However, these problems are made worse by policies that have to do with being too big to fail, deposit insurance, and the last resort lender. The global financial crisis uncovered the huge failures of the regulatory system and the potential contradictions between competition policy and regulatory intervention (Koskela & Stenbacka, 2000: 1857). Banks, indeed, are unique because of their specific mix of features that increases their vulnerability to potential systemic impact and very fundamental negative externalities with regards to the economy (Koskela & Stenbacka, 2000: 1858). The competitive banking system’s fragility is excessive with financial regulation coming to the rescue at the cost of regulatory failure and side effects. The most essential one has to do with potential moral hazards caused by bailouts and protection of failing financial institutions. The recent global financial crisis is a testimony to failures of the Basel II system’s three pillars. First, risk assessment and disclosure have been deficient with market discipline being ineffective, especially due to blanket insurance from too big to fail policies (Koskela & Stenbacka, 2000: 1858). Secondly, capital regulation has failed to account for account systemic effects, i.e. failure’s social costs, with restriction on assets lifted because of pressure emanating from lobbies on behalf of investment banks. Finally, supervision has become ineffective because it has allowed for shadow systems of banking growing without checks. Trade off between Competition and Stability Competition in the banking sector can be defined as the process via which rivalry between banks in competition, within appropriate frameworks regarding prudential regulation, giving businesses and consumers lower prices, greater choice, and better service (Berge et al., 2004: 440). One useful definition with regards to financial stability is given by the Governor of the Bank of England. The governor defines it as financial stability that prevails at the time when there is sufficient resiliency in the financial systems, and worries regarding the bad state of global matters do not lead to an effect on confidence concerning the system’s ability to deliver the core services it provides to the rest of the economy (Berge et al., 2004: 440). The definition as it is implies that there should not and cannot be a guarantee that all banks will be able to survive all crises and, as such, a guarantee would impose a cost that would be too high for the remainder of the economy. The important issue is that the system of banking is sufficiently stable to weather shocks, not that every bank will survive the shock. The relationship between stability and competition is not clear-cut like in the traditional theory of industrial organization. The view, for some time, was that competition exacerbates stability with intense competition seen as being in favor of taking risks on the side of assets, which leads to a higher likelihood that individual banks will fail (Berge et al., 2004: 442). This rationale underlies the charter value hypothesis, which increased profits that induce the banks to put a limit on their risk exposure to enjoy high returns and avoid failure. As competition reduces the charter value of the banks and pressures its margins, increased competition gives incentives to banks so that they can take more risks. The theory of charter value predicts that increased value of charter and decreased competition would allow the banks more incentive in risk containment. However, these so called charter values are, more often than not, little more than amortized rent that results from combinations of abuse of market power, cartelization, and poor regulation. Under these conditions, there are incentives, for charter banks, to acquire even more risk since they are safe in the knowledge that they cannot fail as they are too big (Berge et al., 2004: 443). If these rents are eroded by competition, it could induce increased taking of risks. The hypothesis of charter value has been challenged in various contributions regarding the financial stability vs. competition debate. The too big to fail aspect has been discussed in the context of the architecture of financial systems where interconnectivity between various banks has a crucial influence on systemic risk with these risks ever increasing (Berge et al., 2004: 444). Under these types of structures, damage to highly connected or large banks has disastrous systemic effects with bailouts needed to reduce or prevent this systemic risk. Banks, aware of this, are further incentivized to become more complex and larger knowing that they will gain since risky activities undergo privatization while catastrophic losses can undergo socialization. Again, this is suggestive of the design of financial regulation being as essential as the structure of the markets for the banking sector’s stability (Berge et al., 2004: 445). This argument contends that complex and large banks pose systemic risks from a structural viewpoint, although they may be incentivized to boost their risk levels in relation to risks taken by less complex and smaller institutions. Large banks in the United Kingdom have a benefit in credit ranking that is reflective of government support expectations, as well as expectations of lower costs of funding (Hakenes & Scnabel, 2011: 256). The subsidy that is estimated is equivalent to their yearly profits. Following the assumptions that implicit subsidies meant for banks that are systematically important, it is worth asking whether competition was weaker before the crisis than was previously assumed. Whatever the view that is taken concerning the extent to which behavior of the banks was distorted because of implicit guarantees in the lead up to the crisis, it has become increasingly likely that there will be distortion of competition in the future unless there is curtailment through policy. What once appeared as implicit bank liability guarantee has now become explicit through emergency banking legislation like credit institutions. Policy directions now contend that banks are too important, too interconnected, and too big to fail. It is now apparent that the too big to fail issue needs to be addressed through structural reform. Only if there is ring fencing of traditional retail banking can the taxpayer guarantees attain limitation to business and personal depositors, and funding by the government for the banking system to be directed towards business needs that create growth and jobs. This is an irrefutable case for recommendations from the Vickers Commission (Hakenes & Scnabel, 2011: 256). The suggestion that unregulated competition is unreservedly good for banking is a naive position. The activity of individual banks, as well the proliferation of innovative products, needs to be regulated with it being incumbent on the regulators to comprehend fully systemic risks that are caused by banks and their collective behavior. However, an inert system of banking that cannot take risks and give innovative services and products also threatens growth prospects in the entire economy (Hakenes & Scnabel, 2011: 257). Financial stability is dependent on effective regulation, corporate governance, diversity of adopted strategies, the design of incentives, and the degree to which banks are interconnected. Stability of banking systems that are appropriately regulated, in particular, will gain from competing business models, which can only be offered in a structure of competitive markets. Financial stability can be achieved through absorbance of loss and flexibility of structures. Capital requirements or deposit insurance that is risk adjusted commensurate with the bank’s lending book’s riskiness is representative of a better approach to dealing with financial stability compared to competition curtailment (Hakenes & Scnabel, 2011: 257). Excessive incentives for risk taking can be solved via liquidity and better capital regulation and not through tolerating decreased competition. Empirics and theories point to the presence of trade offs between stability and competition along various dimensions. Runs occur independently on the competitive level, although increased competitive pressure exacerbates the problem in coordination of depositors/investors potential appreciation of instability, impact of negative news on essentials, and the probability of a crisis (Berger et al., 2009: 104). This, however, does not imply that there should be minimization of competitive pressure because, generally, there is a positive, optimal probability of crises due to the effect it has on discipline. On the side of assets, on reaching a specific threshold, increments on competition levels tend to boost incentives for taking risks, as well as the probability that banks will fail. This tendency could be checked through appropriate supervision and regulation. The evidence is indicative of liberalization leading to increment of bank crises while adequate regulations and strong institutional structures reduce them (Berger et al., 2009: 105). Similarly, there is a positive association between stability and various measures towards bank competition, for instance, openness to entry by foreigners and low barriers to entry. Regulation has the ability to alleviate the trade off between competition and stability, although the optimal regulation design has to account for competitive intensity. Capital charges, for example, need to reflect the degree of rivalry and friction in the banking sector with requirements being tighter in situations that are more competitive. Given that regulative fine tuning has proved to be difficult in practice, which is an understatement given massive failures of regulation that was uncovered by the crisis; competition and stability tradeoff are expected to persist (Carlson & Mitchener, 2006: 1300). This suggests that coordination of competition policy and regulation is needed. The unique nature of banks as discussed above should be recognized, when not only there is a crisis, and the appropriate lessons need to be drawn, but also applied, during the implementation of competition policy. Policies on mergers in the banking sector need to be consistent over time, considering optimal level of dynamic incentives and concentration (Carlson & Mitchener, 2006: 1302). However, the problem on how to deal with institutions that are too big to fail, as discussed, remains an open issue. In the United States, this problem is not one of anti-trust; whereas, in the European Union, control of competitive distortions by the competition authority arising from state aid has major implications for institutions that are too big to fail. The competition authority’s credibility in imposing conditions when institutions have been aided may provide a device for the commitment that has been absent in bailout situations (Carlson & Mitchener, 2006: 1302). There are problems with regard to size controls since the line of business specialization and interconnectedness are of increased relevance to systemic risk compared to the size. Conclusion Policy concerning competition recognizes the role that banks play in support of the entire economy, as well as the exceptional circumstances that the British economy and the European Union face. However, there is a risk that the founding of banking duopoly not only leads to a reduction of competition in the short and medium term, but also worsens the too big to fail issue that has forced the British government to be involved in covering private interest losses. A situation such as this would come about in the case of another crisis if the remaining banks were too big for them to be bailed out. The current strategy goes out to address financial stability, although concerns persist that those measures taken in order to protect the banking sector in the crisis may come at a risk of prolonging the cycle of recession if these policies stop the dynamism that leads to jobs and investments. The big banks, just like other institutions that are sheltered from competition, possess vested interests in the preservation of the status quo. Policy makers face challenges in distinguishing between banking interests that can strongly resist or restore competition and consumer interests, which lie in maintaining competitive and stable banking systems. References Berge, A., Demirguc-Kunt, A., Levine, R., & Haubrich, J., 2004. Bank Concentration and Competition: An Evolution in the Making. Journal of Money, Credit and Banking, 36(3): 433-451. Berger, A., Klapper, L., & Turk-Ariss, R., 2009. Bank Competition and Financial Stability. Journal of Financial Services Research, 35(2): 99-118. Boyd, J., De Nicolo, G., & Jalal, A., 2009. Bank Competition, Risk, and Asset Allocations. Washington, DC: International Monetary Fund. Carlson, M. & Mitchener, K., 2006. Branch Banking, Bank Competition, and Financial Stability. Journal of Money, Credit and Banking, 38(5): 1293-1328. Hakenes, H. & Schnabel, I., 2011. Capital regulation, bank competition, and financial stability. Economics Letters, 118: 256–258. Koskela, E. & Stenbacka, R., 2000. Is there a tradeoff between bank competition and financial fragility? Journal of Banking & Finance, 24(12): 1853–1873. Read More