Competition and Financial Stability - Essay Example

? COMPETITION AND FINANCIAL STABILITY By Lecturer: of Affiliation: and Competition and Financial StabilityIntroduction Financial stability and competition are the main concerns in the current banking sector policy issues across the globe. Many a banking sector has been stricken by banking crises for the past decades due to worldwide financial crisis. Although world wars impacted the banking system, the 21st century has thus far been more stable. The increased competition in the monetary markets has been among the main debating issues over the financial volatility across the globe. The competition is always seen as a requirement necessary for efficiency of the banking system. Although varied theoretical and empirical studies have attempted to argue that monopoly offer banks higher incentives to improve their financial performance, competition in the banking sector have also enabled banks to compete favorably; thus enabling banks to achieve their demanding needs effectively (Schinasi and International Monetary Fund, 2006). This is because of the notion that vulnerability and restraints on competition are necessary for preserving the stability of the banking system in the current financial market; therefore, the essay offers a critical assessment of the trade-offs between competition in the banking system and financial stability. Advantages of Competition Competition is desirable in the banking system because it contributes to increased competitive business performance across the banking sector (Marinc, 2012). The charter-value for competition stability theory assumes that the more concentrated and less competitive banking systems, the higher chances of becoming more stable. The contrasting perspective to this theory is that a more concentrated banking structure may lead to more bank frailty. Boyd, De Nicolo and Jalal (2010) argue that market control in banking system increases profits, but bank steadiness ignores the prospective impact of market powers for banks. The authors argue that the higher interest rates in the banking sector may induce the banking industries to assume greater risks; hence, they find a positive relationship between concentration and bank fragility (Kohn, 2003). Many banking system support competition feebleness and this had significantly contributed to financial volatility in many banks across Canada and the UK. Therefore, the less bank rivalry, the less credit rationing and higher chance of malfunction in case loans are subjected to multiplicative reservations. Competition and higher level of concentration in the banking sector can also create a positive impact on liability menace. Boyd, De, Jalal and International Monetary Fund (2009) argue that less competition in banking system can contribute to more financial stability in case information about the probability distribution of liquidity of the depositor is private. Allen, Carletti, Gale and Centre for Economic Policy Research (2011) assert that it is crucial to prevent banks from taking excessive risks in the competitive markets. Hence, the deposit interest rate ceilings are vital even with capital requirements. Beck, Beck and World Bank (2008) argues that concentration is not a consistent rivalry signal in the banking sector; thus, the bank illiquidity can augment in any fiscal market structure. Therefore, lower competition in the banking system is crucial because it enables banking relationships to endure for a long period. Drawbacks of Competition Competition in the financial market can impact steadiness in the banking system in diverse ways; first, competition can impact financial stability is through the interbank market system and through the payment system channels. Allen and Gale (2000) argue that perfect competition can prevent banks from offering liquidity to other banks that have been strike by short-term liquidity shortage. Therefore, there is no bank that will have adequate incentive to offer liquidity to the banks that have problems in case all banks are price takers. This is because these banks will eventually fail and they will also experience negative consequences in the whole banking system. Limited number of banks can cooperate and act deliberately by helping such banks with short-term liquidity shortages; thus enabling them to perform better in the competitive financial market. Boyd, De Nicolo and Jalal (2009) and Matthews and Thompson (2005) both argue that competition can create impact on the financial stability and contribute to varied risk types in the banking system. Using their models of investments decisions in form of moral hazards, both authors agree that the higher interest rates can lead to banks taking riskier investment activities. Therefore, with higher rate of banking competition, banks may encounter risks, but they can optimally choose to leverage in response to their changing competitive environment (Freix and Ma, 2013). This is through employing a simple theoretical framework where banks can take higher leverage and take banking risks with an aim of increasing profits. Tradeoff between Competition and Stability Freixas and Ma (2013) argue that understanding the relationship between the bank competition and financial stability is crucial for designing an effective banking industry and its appropriated regulation. The theoretical contest has been raised over the impact of bank rivalry on the solidity of the banking system. The ambiguity behind this debate stems from problems in making choice of effective measurements for measuring the financial stability in the banking system process. Boyd, De Nicolo and Jalal (2010) offer theoretical contributions for considering bank liquidation risks and also indicates the way competition decreases charter values and incentives of the banks; thus affecting the bank stability. The authors argue that to offer effective incentives for monitoring borrowers, banks should hold more capital. This is because capital and bank loans rates are alternative measures for improving monitoring incentives of the bank. Allen and Gale (2000) argue that the incentives for banks to monitor borrowers are reduced as competition decreases the charter values. Although, holding more capital in the competitive market is crucial, the relationship between competition and stability depends upon the liability structure of banks. Establishing the relationship between banking competition and liquidation risks depends upon the liability structure where the banks are financed by stable funds such as uninsured short-term wholesale funding or insured retail deposits (Freixas and Rochet, 2008). For instance, using the funding and liquidity risk model, each bank can hold a unit portfolio of loans and finances it with equity and debt. Therefore, the banks may decide to leverage in order to exploit the equity cost of existing banking shareholders. Each bank may decide to issue the total amount of debt, which promises a repayment. Capital may be costly because of market imperfections and this may occur because of bankruptcy costs; thus, the optimal leverage ratio will trade-off the benefits of debt tax with the expected bankruptcy costs (Freix and Ma, 2013). Varied theoretical models have been employed in order to reveal the connection between competition and banking stability, as well as the risks that may arise in the banking system. Varied theories and empirical research studies have attempted to reveal the way competition in the banking system is a necessary condition for effective banking system (Vives, 2010). However, these theoretical and pragmatic studies have not yet found effective conclusion linking bank rivalry and banking market stability. There is a belief that excessive competition can contribute to vulnerability and restraints on competition are necessary for preserving the stability of the banking system (Beck, 2010). After the fiscal crisis of 1930s, many manufacturing nations established the explicit goals of restricting competition in the financial activities. The fiscal liberalization of the 1970 to 1980s that led to unconstrained antagonism has often been blamed for consequent banking vulnerability across the globe. The recent unregulated competition in the financial system in the United States has also been partly blamed for increased problems in the subprime credit market. Beck, Beck and World Bank (2008) reveal that banks in some countries have reached mixed conclusions on the relationship between competition and risk in banking, but the cross-country studies attempts to reveal a positive relationship between competition and banking stability of banking systems. This has been done through carrying out standard measures by using varied models such as HHI (Hirschmann-Hirfendahl Index), which is linked with price cost-margins. The HHI is an effective standard measure for determining the competitive degree for the banking system across the globe. Thus, competitive degree and the concentration measures should be restricted on certain factors because both banking system and financial markets are heterogeneous. This is because banks differ with respect to economies of scale and cost structures. HHI theory reflects the way banks can gain high market shares by setting prices lower than their competitors. The market may differ in respect to size and demand for banking services; thus, HHI model takes into account market size when measuring competition levels in varied financial markets (Avgouleas, 2012). Competition and stability are not incompatible; thus, there is no need for applying weaker competition policy criteria to banks (Beck, 2010). Thus, varied theories or frameworks have been employed for measuring competition levels and also to determine the stability of the banking system. The theoretical models have made contrasting forecasts on the correlation between steadiness and rivalry in the banking system. The forecasts vary in dynamic and static approaches, as well as, have significant relations with regulatory framework elements (Colander, 2008). For example, some theories predict that less rivalry and more intense banking system are steadier; thus, profits offer incentives against any financial risks. However, bank owners can transfer monetary risks to the depositors, but this is one way of involving in the up-side part of menace taking. Therefore, in the competitive environment, banks can take risks of getting higher profits and incentives, but this may result due to higher fragility in the banking system. Consequently, banks can achieve higher revenue opportunities and less incentive in a controlled market entry or in a restricted competition. Gale and Yorulmazer (2011) developed a model of liquidity hoarding in order to reveal the way banks distribute liquid assets. For example, the Central Banks can decide to be illiquid because they are the sole lenders of liquidity. Thus, the authors developed constrained efficiency policy in which the planner accumulates and distributes liquid assets (Gale and Yorulmazer, 2011; Degryse Kim and Ongena, 2009). Bankers receive liquidity shocks in case the bankers’ creditors demand repayment starting from date one or two. In the laisser-faire economy, bankers are initially endowed with one unit of their assets and another one for cash (Cecchetti and Schoenholtz, 2011). Therefore, at date zero, bankers may choose whether they can consumer their cash immediately or retain one unit of their portfolios for future purpose. The laisser-faire model is effective because it is one of the marketing clearing conditions that bankers employ in distributing liquidity assets; thus enabling them to maintain stability in the banking process. Freixas and Rochet (2008) reveal the way banks can manage risks because this is one of their major activities that can enable them to improve their business performance. Commercial and investment banks, as well as mutual funds have to take control or select the risks inherent in managing their deposits, loans portfolios and off-balance sheet contracts (Freixas and Rochet, 2008; Dunaway and Council on Foreign Relations, 2009). Varied microeconomics risks have been put forward by economist because there are diverse risks that banks have to manage. Among these risks, liquidity risks appear to be the major risks that many economists have attempted to focus about. Therefore, this risk occurs when a bank makes unexpected cash payments (Carletti and Leonello 2013). Other risks include credit and interest rate risks; thus they are likely to contribute to stability; thus impacting the performance of business. Conclusion In conclusion, the essay offered a critical assessment of the trade-offs between competition in the banking system and financial stability. The research examined the way competition can impact stability in the banking system in varied ways. First, it revealed the way less competition and more concentration in the banking system can have a positive consequence on liability risk. Another way through which competition can impact financial stability is through the interbank market system and payment system channel. It analyzed some theoretical models that have been employed in order to reveal the connection between competition and banking stability, as well as the risks that may arise in the banking system. These theories or frameworks have been employed for measuring competition levels and also in determining the stability of the banking system. Thus, the research revealed that banks can manage risks because this is one of their major activities, which can enable them to improve their business performance achieving a competitive advantage in the global market. Bibliography Allen, F., and Gale, D. (2000) Comparing financial systems. Cambridge, Mass: MIT Press. Avgouleas, E. (2012) Governance of global financial markets: The law, the economics, the politics. Cambridge, U.K: Cambridge University Press. Allen, F., Carletti, E., Gale, D., and Centre for Economic Policy Research (Great Britain) (2011) Money, financial stability and efficiency. London: Centre for Economic Policy Research. Beck, T. (2010) Bailing out the banks: Reconciling stability and competition. An Analysis of State-Supported Schemes For Financial Institutions. London: Centre for Economic Policy Research, 1-92. 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