Competition in Commercial Banking: Systemic Risk - Literature review Example

Competition in Commercial Banking: Systemic Risk Competition in Commercial Banking: Systemic Risk Systemic risk can be referred to as a financial risk whose occurrence makes the entire financial market collapse rather than the failure of single entities. The main cause of this risk is an external event like competition and rarely is it caused by endogenic factors. When it happens it creates and amplification mechanism linking different elements of the financial system and turning minor events into major crisis. Furthermore, failure of one financial institution can also trigger systematic risk. This happens if it has great influence in the market since its failure will cause other interconnected institutions suffer. This paper is going to analyse this risk while focusing on the continuous rise in commercial banking competition as causative agent of the same. In addition to that, it will analyse the implication of systemic risks to policy makers. Financial intermediaries such as banks play a very significant role in regulating credit provision within a given economy. This is because, while borrowers are risky, banks have strategies that enables them monitor how these borrowers use their loan both before and after borrowing. If however, the channels through with banks give credit are disrupted, either through insolvency or capital shocks, the banks will run short of finances meaning that investors will not have access to sufficient loans. If all investors lack capital to invest, the market will eventually collapse due to economic dormancy leading to systemic crisis. Moreover, healthy competition coupled with frequent trading, banks increase market efficiency and liquidity by ensuring continuous circulation of regulated cash flows in the market. As a result, market stability, lower volatility and stabilisation of prices sets in the market. Below are some factors which are outcomes of competition and which put the banks at risk and incapacitate them from providing credit hence leading to systemic crisis. According to Allen, Carletti, and Marquez (2009), competition enable commercial banks have easy access to hedge fund-unregulated capital. In the short-run, most commercial banks invest a lot so as to gain larger market shares. However, if a bank has a larger exposure to hedge fund, its capability and willingness to offer credit is thwarted because of the great risk it is exposed to. The bank may opt to collateralise its credit exposure but this may not be a solution. This is because, if a spontaneous decline of asset prices is triggered by the slowdown of a high leveraged fund, it substantially reduces the value of that collateral. Such extensive decline in collateral values may make investors become risk averse when making decision on whether to invest or not. In addition to that and according to Barth, Caprio and Levine (2000), decrease in asset value mean a reduction in collateral value which means that affected banks will lose the ability to borrow thus amplifying the initial impact of shock. If the banks are capacitated to the extent that bank-dependent people cannot borrow from these banks, investment and other economic activities are curtailed leading to systemic crisis. The forces of competition have adverse effects on managerial decision making and the general performance of a firm. Despite the fact that competition is important to all sectors of economy, forces of competition and are potential vulnerabilities to bank regulators and policy makers, owing to the risk taking behaviours of banks. As a result, financial analysts, credit rating agencies and investors seeking future prospects of banks, should put it into consideration. The Federal Reserve’s Commercial Bank Examination manual, in section 2080.1, asserts that “owing to the fact that lenders are subject to pressure pertaining to productivity and competition, they may be tempted to revise down prudent credit underwriting standards to remain competitive in the market place, and in the long-run, they increase the potential of risk (International Monetary Fund, 2001).” According to this source, it means that increase in competition leads to decrease of bank’s underwriting standards and increases risk to the bank. This is to say that, as the level of competition increases, the number of borrowers to the bank increases. It is important to understand that some of these borrowers may not have necessarily qualified for the loan. But since the bank want to remain relevant in the market, it has to lend more so as to retain customers. If all the banks in the financial sector lend money to borrower, it leads to financial crisis hence caused by a banking system hence systemic risk. Similarly, Berger, Demetz & Strahan (1999) suggests that in times of competition, banks revise down their interest rates with and endeavour to maintain their lending volumes. In other words, the bank’s competitive environment not only leads to bank lending to riskier borrowers, it also impacts the bank with the willingness to receive less compensation from per unit of risk. In addition to that, Cameron (1991)argue that degree at which commercial banks monitors the loan given to borrowers is directly proportional to the restrictions attached to that particular loan. That is, if there are too many restrictions in getting a loan, it will be extensively monitored and vice versa. On the other hand, may not be attractive to borrowers since most of them do not like loans that have too many attachments. In an environment commercial banks are competing, they may relax these restrictions with and endeavour to attract more borrowers and either maintain or increase their loan volume for the bank. In doing so, as single entity, affects the bank and the whole banking industry leading to a systemic crisis. Carlsson and Damme (1993) confirms that increasing competition in commercial industry compel bank managers to scale down timelines of recognising their bank expected losses. As a result, these managers delay the anticipated financial loss to future periods. Even though the bank may reap higher financial profitability at the present moment, it does at the expense of lower expected future financial returns. In other words, when the level of competition increases putting downward pressure on the profit of the bank, manager respond by propping up earnings of the bank by delaying recognition of anticipated losses from the loans. Similarly Claessens and Laeven (2004) notes that in highly competitive environments, managers buoy up profits concealing the escalating risk of their assets portfolio. This is very dangerous since in such a phenomenon, the bank will be operation at assumed future profits. It is worth noting that delaying recognition of anticipated financial loss has an imaginable consequence on credit supply and bank risk shifting leading to contraction of balanced sheet which in turn leads to systemic risk. As to conclusion, increase in competition may finds its way through decisions made by managers thus generating substancial externalities that may outspread profitability of the bank as reported by the manager. According to De Nicolo (2000) increases competition should not be an opportunity for management to manipulate financial reporting. He proposes external monitoring of financial records as a method of mitigating this misconduct by bank managers. Even though external auditing is fundamental, it is never uniform and varies greatly depending on which organisation provides the service. A good example is Big 5 and non-Big 5 auditors. While the former monitors and discipline financial misconducts more aggressively, the latter does not. According East Asia Analytical Unit (1999) good external auditors should offer resistance to a bank manager’s efforts to alter financial recording and delay expected loan losses. Though the presence of external auditors is crucial in mitigating earning management, they do not influence such systemic risks associated with increase in level of competition in commercial banks. According to Euromoney (2000) banks pursue in non-interest activities during times of stiff competition. This is to say that when completion becomes tough, commercial banks tend to seek financial support from non-interest financial activities like investment banking, venture capital and trading activities and this tend to put the bank into a risk. Research has proved that income generated from non-interest activities is extremely volatile and has low returns to the bank. This is to say that, these activities demand a lot of investment yet their returns vary unpredictably. Focarelli and Pozzolo (2000)found out that banks that engage in non-interest activities exhibits a higher contribution to systemic risks that traditional banks which do not engage in such activities and this is brought by increase in level of increasing competition by commercial banks. Statistically, risks in commercial banks decreases up to the 25th percentile of non-interest income and then goes up. From the above information banks pursues non-interest sources of income during times of competition. According to Goldstein and Turner (1996), during times of stiff competition, banks pursue these non-interest means of income to increase their income mix with and endeavour to supplement declining interest margins which in the long-run increases risks to the bank hence systemic risk. It is important to understand that most financial institutions, especially commercial bank, raise their revenues through portfolios. A portfolio is a collection of assets or investments that a particular financial institution has. If a financial institution wants to raise money, they sell the portfolio to specific investors on an agreement that the bank will redeem those portfolios at the agreed time. In times of low competition, they sell these portfolios to potential investors in the market. In most cases, the portfolios sold are usually risky ones. This is because risky portfolios usually have high returns. When competition increases, the creditors to these portfolio may withdraw before the bank’s risky portfolio matures. If that happens, the bank will have no alternative that sell the portfolio at a discounted value (Kane, 1999). In such an instance, the liquidation value of the asset may either be insufficient to repay the early withdrawals or the available cash may be sufficient to pay withdrawals but will not be able to pay creditors. In such a situation, the bank is insolvent and will have to incur bankruptcy costs. On the other hand, while one bank is suffering economic loses, other banks may be benefiting from the same increase in competition level. It has been noted above that increase in competition makes banks revise down interest rates on their portfolio (Lee, 2000). Though this has a negative effect on the bank, it is an opportunity for investors. Investors end up investing more on portfolios. A bank that has the ability of selling its portfolios at lower interest rates will make more revenue than the other banks. Therefore, while other banks in the industry may be benefiting other may be suffering or the latter may happen to the entire banking industry leading to systemic crisis. Competition affects market value of all the assets that the bank has put in the market. It is hard to determine market value of assets and as a result, returns on equity are used to change the book value of an asset into market value. Anything that affects the value of equity will also affect the value of the asset (Mathieson, & Roldos, 2001). In order to measure the tails risk of an asset, Value at Risk (VaR) techniques is used. When the price of an asset or a portfolio moves 3 standard deviations away from it current prices, it is said to exhibit tail risk. This method enables one to determine that value of a risky asset within a defined period of time given a confidence interval. Assuming that a bank has a VaR of -15% in a given week, at a 95% confidence level, this means that there is a chance of 5% that the value of the equity will drop by 15% million in that particular week (McAllister, & McManus, 1993). Research conducted by Group of Ten (2001) has revealed that if competition of commercial banks increases progressively, it negatively affects bank’s asset and equity value. This leads to the conclusion that the more the level of competition, the severe the risk faced by commercial banks. It is important to understand that investors enter the market fully aware of the level of competition, benefits and loses and as a result there should never be regulation or intervention. This is because, if additional regulations are put, they would result in less social interactions which will in turn lead to reduced economic activity. In the long-run, competition will be limited leading to stifled innovation (Rhoades, 2000). On the other hand, if systemic risk brings an externality or public-good problem that will hinder smooth operations within the market then, there is need for regulation. For this policy to be effective, it should identify and quantify the externality so that appropriate policies can be generated out of it. In other words, it the systemic risk dates its origin from a bank, the banks themselves should come up with effective policies that will enable them mitigates the risk. As to conclusion, increase in level of competition puts commercial banks in so many risks. One, it leads to delays in recognising expected losses and as a result makes banks pursue non-interest tactics of generating income which according to research have volatile returns. By so doing, the bank becomes prone to systemic risks thus making them more susceptible to economy-wide shocks. Increase in competition makes banks invest most of their wealth in the market. This deprives them the ability to give loans. If all the banks face the inability to offer credit, a financial crisis sets in leading to systemic crisis. Due to competition, banks become lenient in offering loans and reduce their underwriting standards which puts them to risk for the debtors may default repaying the loans due to lack of strict rules. Increase in competition, compels manager to inflate earnings while deferring expenses, this conceals increasing risk on the bank’s portfolio. Competition makes bank adopt a desperate measure of pursuing non-interest investments which are risky but with low returns. As to conclusion, banks should understand the profits and loses that emanate from unhealthy competition. This will enable them come up with relevant policies that would govern the entire banking industry for the sake of the industry’s well-being. References Allen, F., E. Carletti, & R. Marquez (2009): “Credit Market Competition and Capital Regulation,” Review of Financial Studies, 24(4). 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