Skip to main content

Bank Competition and Financial Stability

Abstract

Under the traditional “competition-fragility” view, more bank competition erodes market power, decreases profit margins, and results in reduced franchise value that encourages bank risk taking. Under the alternative “competition-stability” view, more market power in the loan market may result in higher bank risk as the higher interest rates charged to loan customers make it harder to repay loans, and exacerbate moral hazard and adverse selection problems. The two strands of the literature need not necessarily yield opposing predictions regarding the effects of competition and market power on stability in banking. Even if market power in the loan market results in riskier loan portfolios, the overall risks of banks need not increase if banks protect their franchise values by increasing their equity capital or engaging in other risk-mitigating techniques. We test these theories by regressing measures of loan risk, bank risk, and bank equity capital on several measures of market power, as well as indicators of the business environment, using data for 8,235 banks in 23 developed nations. Our results suggest that—consistent with the traditional “competition-fragility” view—banks with a higher degree of market power also have less overall risk exposure. The data also provides some support for one element of the “competition-stability” view—that market power increases loan portfolio risk. We show that this risk may be offset in part by higher equity capital ratios.

This is a preview of subscription content, access via your institution.

Notes

  1. 1.

    Note that franchise value deters bank risk taking to the extent that owners believe that their ownership of the bank is at risk in the event of insolvency. If regulators are expected to forbear and leave ownership intact, the owners may not have significant incentives to control risks (Frame and White 2007).

  2. 2.

    Alegria and Schaeck (2008) show that bank concentration measures are sensitive to the number of banks in each country and that their choice affects the inferences regarding the degree of competition.

  3. 3.

    The list of countries and the number of banks are included in Appendix 1.

  4. 4.

    Conversely, as competition in the loan market rises, Koskela and Stenbacka (2000) construct a model to show that project-holders will increase their investments because of lower lending rates. The authors argue that competition into the credit market will reduce bankruptcy risk of borrowers and conclude that there is no trade-off between lending market competition and financial fragility.

  5. 5.

    We also include the volume of nonperforming loans to total equity for robustness.

  6. 6.

    A potential problem with the Lerner index, as we calculate it, is that we take as given the ratio of interest expenses to deposits, W 2, which may itself embody market power in the deposit market.

  7. 7.

    We thank the anonymous referee for pointing out that, in a perfectly competitive environment, a larger Lerner index can be associated with firms taking on more risk for given marginal costs.

  8. 8.

    Among the tests for heterogeneity, we employ the Pagan–Hall, White/Koenker and Breusch–Pagan/Godfrey/Cook–Weisberg tests, but we only report the results of the Breusch–Pagan/Godfrey/Cook–Weisberg tests.

  9. 9.

    In order to test for endogeneity, we report the results of the First Stage F test; we also report the results of the Hansen’s J test of overidentification.

  10. 10.

    The developed nations correspond to the International Monetary Fund definition for “high-income” countries.

  11. 11.

    First-stage regression results are provided in Appendix 2.

  12. 12.

    One reason why equity capital and stability are positively related is that capital is built up through inertia as retained earnings. That is, higher ROA generates more equity capital as dividend payouts are relatively fixed (e.g., Berger 1995; Berger et al. 2008).

References

  1. Alegria C, Schaeck K (2008) On measuring concentration in banking systems. Finance Res Lett 5:59–67 doi:10.1016/j.frl.2007.12.001

    Article  Google Scholar 

  2. BankScope (2007) Bureau Van Dijk

  3. Barth J, Caprio G, Levine R (2007) Bank regulation and supervision (updated dataset), WB working paper series no. 2588

  4. Beck T, Demirguc-Kunt A, Levine R (2006) Bank concentration, competition, and crises: first results. J Bank Finance 30:1581–1603 doi:10.1016/j.jbankfin.2005.05.010

    Article  Google Scholar 

  5. Berg SA, Kim M (1994) Oligopolistic interdependence and the structure of production in banking: an empirical evaluation. J Money Credit Bank 26:309–322

    Article  Google Scholar 

  6. Berger AN (1995) The relationship between capital and earnings in banking. J Money Credit Bank 27:432–456 doi:10.2307/2077877

    Article  Google Scholar 

  7. Berger AN, Demirguc-Kunt A, Levine R, Haubrich J (2004) Bank concentration and competition: An evolution in the making. J Money Credit Bank 36:433–451 doi:10.1353/mcb.2004.0040

    Article  Google Scholar 

  8. Berger AN, DeYoung R, Flannery MJ, Lee D, Oztekin O (2008) How do large banking organizations manage their capital ratios? J Financ Serv Res 34:123–149 doi:10.1007/s10693-008-0044-5

    Article  Google Scholar 

  9. Boyd J, De Nicolo G (2005) The theory of bank risk taking revisited. J Finance 60:1329–1343 doi:10.1111/j.1540-6261.2005.00763.x

    Article  Google Scholar 

  10. Boyd J, De Nicolo G, Jalal AM (2006) Bank risk taking and competition revisited: New theory and evidence, IMF Working paper, WP/06/297

  11. Carletti E, Hartmann P (2003) Competition and financial stability: what’s special about banking? In: Mizen P (ed) Monetary history, exchange rates and financial markets: essays in honour of Charles Goodhart, vol. 2. Edward Elgar, Cheltenham, UK

    Google Scholar 

  12. Claessens S, Laeven L (2004) What drives bank competition? Some international evidence. J Money Credit Bank 36:563–583 doi:10.1353/mcb.2004.0044

    Article  Google Scholar 

  13. Demsetz R, Saidenberg MR, Strahan PE (1996) Banks with something to lose: the disciplinary role of franchise value. Fed Reserve Bank N Y Econ Policy Rev 2(2):1–14

    Google Scholar 

  14. De Guevara JF, Maudos J, Pérez F (2005) Market power in European banking sectors. J Financ Serv Res 27:109–137

    Article  Google Scholar 

  15. De Nicolo G, Loukoianova E (2006) Bank ownership, market structure, and risk, Unpublished Working Paper, International Monetary Fund, Washington, D.C.

  16. Djankov S, McLiesh C, Shleifer A (2007) Private credit in 129 countries. J Financ Econ 84:299–329 doi:10.1016/j.jfineco.2006.03.004

    Article  Google Scholar 

  17. Frame WS, White LJ (2007) Charter value, risk-taking incentives, and emerging competition for Fannie Mae and Freddie Mac. J Money Credit Bank 39:83–103 (February)

    Google Scholar 

  18. Hall AR (2005) Generalized method of moments. Oxford University Press, Oxford

    Google Scholar 

  19. Hansen L (1982) Large sample properties of generalized method of moments estimators. Econometrica 50:1029–1054 doi:10.2307/1912775

    Article  Google Scholar 

  20. Hellmann TF, Murdock K, Stiglitz J (2000) Liberalization, moral hazard in banking and prudential regulation: are capital requirements enough? Am Econ Rev 90:147–165

    Google Scholar 

  21. Huizinga H, Laeven L (2008) International profit shifting within European multinationals: a multi-country perspective. J Public Econ 92(5–6):1164–1182 doi:10.1016/j.jpubeco.2007.11.002

    Article  Google Scholar 

  22. Jimenez G, Lopez J, Saurina J (2007) How does competition impact bank risk taking? Working paper, Banco de Espana

  23. Keeley M (1990) Deposit insurance, risk and market power in banking. Am Econ Rev 80:1183–1200 (December)

    Google Scholar 

  24. Koskela E, Stenbacka R (2000) Is there a tradeoff between bank competition and financial fragility? J Bank Finance 24(12):1853–1873 doi:10.1016/S0378-4266(99)00120-X

    Article  Google Scholar 

  25. Marcus AJ (1984) Deregulation and bank financial policy. J Bank Finance 8:557–565 doi:10.1016/S0378-4266(84)80046-1

    Article  Google Scholar 

  26. Martinez-Miera D, Repullo R (2008) Does competition reduce the risk of bank failure? Unpublished manuscript, CEMFI

  27. Molyneux P, Nguyen-Linh H (2008) Competition and risk in the South East Asian banking, Bangor Business School working paper, Bangor, Wales

  28. Schaeck K, Cihak M (2007) Banking competition and capital ratios. IMF Working Paper No. 07/216

  29. Schaeck K, Cihak M, Wolfe S (2006) Are more competitive banking systems more stable? Unpublished Working Paper No. 143, International Monetary Fund, Washington, D.C.

  30. Shaffer S (2004) Comments on what drives bank competition: some international evidence, by Stijn Claessens and Luc Laeven. J Money Credit Bank 36:585–592 doi:10.1353/mcb.2004.0050

    Article  Google Scholar 

  31. Stiglitz JE, Weiss A (1981) Credit rationing in markets with imperfect information. Am Econ Rev 71:393–410 (June)

    Google Scholar 

  32. World Bank (2006) Doing business. The World Bank, Washington, D.C.

    Google Scholar 

Download references

Author information

Affiliations

Authors

Corresponding author

Correspondence to Allen N. Berger.

Additional information

The authors thank an anonymous referee, Lamont Black, Tim Hannan, Tim Koch, Klaus Schaeck, and conference participants at the Financial Management Association 2008 meeting for helpful comments.

Appendices

Appendix 1

Table 6

Table 6 List of countries and number of banks

Appendix 2

Tables 7, 8 and 9

Table 7 First-stage regressions: dependent variable is nonperforming loans to total loans
Table 8 First-stage regressions: dependent variable is Z-index
Table 9 First-stage regressions: dependent variable is equity to assets

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Berger, A.N., Klapper, L.F. & Turk-Ariss, R. Bank Competition and Financial Stability. J Financ Serv Res 35, 99–118 (2009). https://doi.org/10.1007/s10693-008-0050-7

Download citation

Keywords

  • Bank competition
  • Banking system fragility
  • Financial stability
  • Regulation

JEL classification

  • G21
  • F30
  • L89
  • G38