Competition, Efficiency, and Stability in Banking - Essay Example

Competition, efficiency, and stability in banking

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Competition, efficiency, and stability in banking

1.0 Introduction

1.1. Background of the study

Management of credit risk in financial institutions is a core concern for policy makers, practitioners, and regulators, particularly from the start of the fiscal crisis. A singled out driving force of financial unsteadiness is too much competition in the financial sector. As a result, special attention has been received since the beginning of the financial crisis (Sealey & Lindley, p.2009). Interested stakeholders have produced studies that investigate the relationship between competition, efficiency, and stability.

The academic writing is yet to arrive at an agreement over these conflicting narratives. However, recent theory and proof are pointing towards a positive outcome of competition on bank stability (Schaeck & Cihák, 2013, p.111). On the contrary, conventional literature stipulates that growing competition erodes character values that eventually yield a negative trade-off between competition, efficiency, and stability in the banking sector.

This research will, therefore, revisit the debate empirically, and bring up the question of mechanisms that makes competition contribute to bank stability as stated in recent studies. In spite of its significance for policy and regulation, the mechanism of transmission has remained an underexplored area (Gibson, 2011, p.104). This research, therefore, aims to fill this gap.

Over the past few decades, banks have witnessed consolidations rapidly across the world that has intensified concerns for policy makers on bank concentration. During this period, foreign banks have also been seen entering developing countries. Cross-border mergers have also been witnessed in most financial systems from developed economies especially within Europe. These consolidations have been witnessed happening within many business lines and across business lines (Bikker, 2004, p.18). All these actions have resulted into financial conglomerates which offer both investment and commercial banking pension and insurance fund services.

1.2. Research aim and objectives

The major aim of this proposed study is to examine the relationship between competition, efficiency, and stability in the banking sector. However, some specific objectives are formulated to help achieve the research aim:

• To examine the relationship between competition and stability in the financial sector.
• To provide the current situation, future effects, and implications of competition in the banking industry.
• To establish trends for the data for a period of two years
• To draw conclusion on the effect of completion on banks efficiency and stability

1.3. Scope and limitations

This proposed study is an attempt to examine selected European banks for a period of two years. The sample will cover the following countries; Italy, Germany, Belgium, France, the U.K, Austria, Denmark, and Switzerland, comprising of 17,965 banks-year observations for 3,325 banks (Gibson, 2011, p.104). This research is limited to describing the bank efficiency and performance in Europe using primary researchers and support from the gathered secondary sources.

Essentially, related writing and studies that will be cited in this proposal came from diverse parts of the world so as to illustrate a clearer explanation of the topic of banking, business development, bank performances and efficiency. The results of this research will be limited to information gathered from journals and books (Genberg & Hui, 2008, p.67). While this research is precise to commercial banks in Europe, related studies on countries from other parts of the world will also be assessed and cited.

2.0 Literature review

2.1. Introduction

The question of whether more competition is healthy or unhealthy for the stability of banks is being debated in the academic, policymaking, and regulatory circles. A narrative that emerges over the recent years is that competition among banks is a contributor to their instabilities in many countries. Consequently, a competing narrative has it that these instabilities reflect a weak market discipline and regulatory failures and that banks need more competition to become even stronger (Schaeck & Cihak, 2012, p.114). Padoa-Schioppa asserts that banks would be stronger and resilient to shock if they are strengthened by the gymnastics of competition.

2.2. Review of relevant studies

Both empirical and theoretical models on the relationship between competition, efficiency, and stability in the banking sector make conflicting predictions. Views on this matter are discussed in the literature under two areas: competition-stability approach and competition-fragility approach. In these theories, the concept of competition is considered as the size of the assets of a bank’s balance sheet, portfolio maximization problem, and deposits (Stock & Yogo, 2005, p.204). Though, it is difficult to determine trade-off levels among competition and stability in the banking sector. From the competition-fragility view, where policies protecting financial stability affect banks competition, increasing competition is disadvantageous to financial stability.

The increase in competition in the banking sector distorts financial stability. For instance, intense competition direct banks to undertake the narrowing of profit margin which is a risky activity (Schaeck & Cihak, 2012, p.114). The high risk, therefore, increases the probability of banks insolvency which in turn undermines the confidence of the public in a country’s financial system.

These failures eventually produce a negative externality for both financial and the real sectors with a huge social cost and the problem of moral hazard. Consequently, cases of large and middle-level banks competition are given a consideration as an important shield for stability for this approach.

An increase in the banks market power leads to an increase in their franchise values which is valid as long as the banks are in operation. Due to the opportunity cost of going bankrupt, such banks would be very high, conform with “too big to fail” policy, banks are unwilling to be involved in risky actions; they, therefore, have a higher rate of portfolio low rates of debt or equity holding to lessen the riskiness of the loan.

On the contrary, competition-stability view asserts that an increase in the banks market power may result in an increase in the amount of risk that they are likely to face. Therefore, a decrease in completion leads to an increase in financial fragility. Through an application of high-interest rates, for a high market power, gains more return (Volcker & Frenkel, 2009, p.124). The advocators of competition-fragility approach, much competition may be good for efficiency, but at the same time bad for financial stability.

With regards to completion stability approach, low competition, and a concentrated bank makeup, results into an increase in financial fragility. Additionally, an increase in competition would cause banks to take risks even more. Although increased risk levels utilize the resources of the banks or taking other risk-mitigating measures still enable stability in the financial sector. Therefore, as market power increases, it destabilizes the financial systems and may deform financial stability. As such, the competition-stability approach is advocated as it indicates an increase in bankruptcy as banking concentration increases. The reason for this is because they reject trade-off between concentration and competition (Schaeck & Cihak, 2012, p.114). For this reason, most of the studies on developed economies support the competition-stability view.

As an option to the above opposite views, a third approach that merges the two views can be advocated. In this new approach, the relationship direction between fragility and bank competition could differ depending on the structure of the economy and relations. Within the context, it difficult to make the judgment that is prevalent everywhere.

Consequently, there has been a u-shaped link between competition and bankruptcy. In the risk-shifting effect, this is as a result of more competition leading to less debt level, low credit level, and more banks which are secure. In addition, low levels of debts lead into low levels of income (Padoa-Schioppa, 2001, p.76). Therefore, the low level of income supports the low debts levels losses but leads to risks in banks. As such, economies have tried to establish some balance between stability and competition.

2.3. Theoretical framework

Contrasting predictions have been made by theoretical models on the link between competition, efficiency, and stability of the banking sector. The predictions might differ with both dynamic and static models and they have significant interactions with the regulatory framework elements, like deposits and insurance.

Many theoretical models never make a distinction between structures of the market, such as competition and concentration, but somewhat assume a one-to-one mapping from market structure to the competitive behavior of banks. Therefore, the proposed study summarizes the theoretical literature under two headings, depending whether the model predicts a positive or negative relationship between competition, efficiency, and stability in the banking sector.

2.4. Summary

In summary, the selected model would either predict a negative or a positive link between the three points of concerns which include; competition, efficiency, and stability for the selected European banks.

3.0 Research methodology and design

3.1. Introduction

This section will discuss the research methodology that will be adopted for this study. It will therefore include primary and secondary data variables, population and sampling, development of instruments plus standardizing them scientifically by establishing reliability and reliability, conceptual model, the statistical techniques used for both qualitative and quantitative analysis.

3.2. Research paradigm

There has been an assumption that competition among banks stabilizes them in terms of efficiency and performance. On the other hand, competition is regarded as the driving force to the instability of banks with a reduction in efficiency. This study therefore, would prove or disapprove these two assumptions.

3.3. Data

Both primary and secondary data will be used for this study. As such, secondary data will be used to study the relationship of the financial indicators with the bank performance. The secondary data will be collected for the following variables namely; profitability, efficiency, liquidity, and capital adequacy ratio.

A panel dataset will bring together European banks for a period of two years. The sample will cover Belgium, France, Germany, Austria, Denmark, Italy, Switzerland, and the U.K, and comprises of 17,965 banks-year observations for 3,325 banks. Out of the 17,965 bank-year observations, 5,705 will be for savings banks, 9,297 for cooperatives, and 2,963 for commercial banks.

After a determination of the sampled banks, the sampled size of the employees will be selected for the collection of primary data will be determined using the Krejcie & Morgan Method.

n = X2 * N*P (1-P)

(ME2 * (N-1)) + (X2 *P*(1-P))

Where; n= Sample size

X2= Chi-square for the specified confidence level of freedom

N = Population size ME = desired margin of error

P = Population portion

The data set will be a representative for the major European banking system and will not be affected by problems of selection. The exploitation of these time-series variation will enable us to track competitive dynamics over time (Zarutskie, 2009, p.56). Therefore, Europe provides a fertile ground for analyzing the effects that competition brings since these banks experience changes aimed at creating a level playing ground for competition.

The dataset to be used ends before the recent crisis. The rationale behind the restriction of the sample before the pre-crisis is that the interventions by the government, guarantees, public bailouts, and liquidity support, through the crises disrupts risk-taking incentives and competition as indicated in the recent literature (Hay & Liu, (1997). The expectations of bailouts encourage banks which are protected to intensify and expand the deposit market competition, resulting in compressed margins at competitor banks with an increasing risk-taking incentive.

3.4. Empirical methodology

In general, the experimental approach to measuring competition among banks is alienated into two clusters: conventional and the novel industrial organization techniques. The conventional approach is on the basis of structure, conduct, and performance with an assumption that banks that are in a more concentrated market are more profitable as compared to those which are in a competitive environment (Zarutskie, 2009, p.56).. Therefore, competition among banks can be substituted by structural measures of market concentrations such as Herfindahl-Hirschman index (HHI). On the hand, empirical studies propose that concentration is a poor measure of competition among banks. An alternative approach of measuring competition among banks knows as NIO method that measures the market power directly rather than taking the proxy.

The two popular techniques of measuring competition that is based on NIO technique include Learner Index and Panzar-Rosse models. This study will focus on Learner Index as the major measure of competition among banks. Out of all the different measures, this method is the only measure that can be used at the bank level (Hay & Liu, (1997). Additionally, this method would be a more accurate measure of market strength than the standard concentration measure. Therefore, higher scores on this index would signify lower competition.

4. Expected results

The expected results would show a positive and important link between competition and stability in the banking sector. A positive and important relationship will hold when the risk adjusted profits are used as dependent variables. This would mean that greater competition in the banking environment would enhance stability.

5. Conclusion

Generally, competition is a positive force associated with an increase in efficiency and an enhanced welfare of consumers’. However, it is a controversial issue in the banking sector which makes policymakers be faced with contrasting issues as to whether these competitive forces impacts on bank performance and efficiency positively or whether consolidation poses danger to competition in the banking sector (Beck &Seabright, 2010, p.78). Through the use of bank-level balance sheet statistics for the main European commercial banks, this research aims to clarify these issues. These will be achieved by investigating the link between competition, efficiency, and stability in the banking sector which will be tested using a dynamic panel data Granger causality test.