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Citation: Beck, T., De Jonghe, O. and Schepens, G. (2013). Bank competition and
stability: Cross-country heterogeneity. Journal of Financial Intermediation, 22(2), pp. 218-
244. doi: 10.1016/j.jfi.2012.07.001
This is the accepted version of the paper.
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Permanent repository link: https://openaccess.city.ac.uk/id/eprint/18224/
Link to published version: http://dx.doi.org/10.1016/j.jfi.2012.07.001
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City Research Online
Bank competition and stability: Cross-country heterogeneity
Thorsten Beck
y
Olivier De Jonghe
z
Glenn Schepens
x
Abstract
This paper documents large cross-country variation in the relationship between bank competition and
bank stability and explores market, regulatory and institutional features that can explain this variation. We
show that an increase in competition will have a larger impact on banks’ risk taking incentives in countries
with stricter activity restrictions, more homogenous bank revenue structures, more generous deposit insur-
ance and more effective systems of credit information sharing. The effects are economically large and thus
have important repercussions for the current regulatory reform debate.
Keywords: Competition, Stability, Banking, Herding, Deposit Insurance, Information Sharing, Risk
Shifting
JEL Classifications: G21, G28, L51
The authors would like to thank Charles Calomiris, Fabio Castiglionesi, Hans Degryse, Jakob de Haan, Claudia Girardone, Iftekhar
Hasan, Simon Kwan, Klaus Schaeck, two anonymous reviewers, the editor (Phil Strahan) and seminar participants at ASSA meeting
(Chicago), HEC Paris, Ghent University, Tilburg University, Cass Business School, Roma II Tor Vergata, Université Libre de Bruxelles,
Bangor Business School, the Bank of England, Carefin-Bocconi (Milan) and the FIRS conference (Sydney) for interesting discussions
and helpful comments. Thorsten Beck acknowledges support from the European Commission under Marie Curie Grant, IRG 239469.
Glenn Schepens acknowledges support from the Fund for Scientific Research (Flanders) under FWO project G.0028.08N.
y
CentER, European Banking Center, Tilburg University and CEPR. T.Beck@uvt.nl
z
CentER, European Banking Center, Tilburg University. o.dejonghe@uvt.nl
x
Department of Financial Economics, Ghent University. glenn.schepens@ugent.be
1
1 Introduction
The impact of bank competition on financial stability remains a widely debated and controversial issue, both
among policymakers and academics.
1
The belief that fiercer competition among banks would lead to a more
effective banking system initiated a deregulating spiral in the late 1970s and early 1980s. While the deregulation
of branching and activity restrictions may have resulted in more intense competition among banks, with positive
repercussions for financial depth (?, ?), income distribution (?), growth (?) and efficiency (?), it may as well
have had the unintended consequence of increasing banking sector instability (see e.g., ? and ?). Similarly, the
international process of banking liberalization has gone hand in hand with an increased occurrence of systemic
banking crises in the last two decades of the 20th century
2
, culminating in the global financial crisis of 2007-
2009. However, there is no academic consensus on whether bank competition leads to more or less stability in
the banking system.
A similarly inconclusive debate has been led on the effect of the regulatory framework on banks’ risk-taking
incentives and ultimately bank stability. On the one hand, capital requirements and restrictions on interest rates
and banks’ activities are seen as fostering stability (?); on the other hand, they might lead to rent-seeking and
might prevent banks from reaping necessary diversification and scale benefits. The role of deposit insurance
schemes has been especially controversial. While often introduced to protect small depositors’ lifetime savings
and to prevent bank runs, they also provide perverse incentives to banks to take aggressive and excessive risks.
These perverse incentives are held less in check in weak supervisory frameworks (?).
This paper combines the two literatures and provides empirical evidence that the relationship between
competition and stability varies across markets with different regulatory frameworks, market structures and
levels of institutional development. While we show, on average, a positive relationship between banks’ market
power, as measured by the Lerner index, and banks’ stability, as measured by the Z-score (a gauge of banks’
distance to insolvency), we find large cross-country variation in this relationship. Our results suggest that an
increase in competition is associated with a larger rise in banks’ risk taking incentives in countries with stricter
1
See ?, ?, ? and ? as well as ? and ?. For a recent on-line debate on this topic, see http://www.economist.com/debate/overview/205.
2
For a detailed overview of the timing of systemic banking crises and the timing of deregulation, we refer to ? and ?, respectively.
2
activity restrictions, more homogenous bank revenue structures, more generous deposit insurance and more
effective systems of credit information sharing.
Exploring the variation in the competition-stability relationship is important for academics and policy mak-
ers alike. The academic debate on the effect of competition on bank stability has been inconclusive to date
and by exploring factors that can explain cross-country variation in the relationship, this paper contributes to
the resolution of the puzzle. Policy makers have been concerned about the effect of deregulation and the con-
sequent impact of competition on bank stability but have also discussed different elements of the regulatory
framework that have both an impact on competition and directly on stability, including deposit insurance, capi-
tal regulation and activity restrictions. After the recent crisis, there are reform suggestions focusing on activity
restrictions, capital standards, deposit insurance and the institutional structure of supervision. This paper shows
a critical role for the regulatory framework in explaining the variation across countries and over time in the
relationship between competition and stability and has therefore important policy repercussions.
3
For example,
we conduct a simulation that mimics a post-crisis scenario with more generous deposit insurance schemes and
stronger restrictions on bank activities and, hence, more herding.
4
The relationship between market power and
soundness is almost twice as large compared to the average country in the absence of such a change, suggesting
a very negative impact of competition on stability in this scenario. In the base scenario, a one standard devia-
tion reduction in market power leads to a drop in the Z-score of 17%. In our fictitious post-crisis scenario
5
, a
similar loss in market power leads to a 37% reduction in the average Z-score. This economically large effect of
regulatory reform comes in addition to any direct effect (positive or negative) that such reforms might have on
banks’ stability. It also widens the trade-off between positive effects of competition on efficiency, on the one
3
If such a country-specifc factor affects both competition and banking sector stability, then a spurious relationship between com-
petition and stability may be the outcome. Therefore, by including country-year fixed effects, we only exploit the within country-year
variation in bank market power and bank soundness. More detailed information is in the Methodology section.
4
This simulation scenario, which reflects recent regulatory reforms or reform suggestions, is based on the results reported in Table
6.
5
The results of this fictitious post-crisis scenario are similar whether or not we include the period 2007-2009 in the estimation. In
a robustness check, we show that neither the 2007-09 crisis in particular or other systemic banking crisis in general affect our main
findings.
3
hand, and negative effects of competition on stability.
Our paper builds on a rich theoretical and empirical literature exploring the relationship between compe-
tition and stability in the banking system.
6
On the one hand, the competition-fragility view posits that more
competition among banks leads to more fragility. This “charter value” view of banking, as theoretically mod-
eled by ? and ?, sees banks as choosing the risk of their asset portfolio. Bank owners, however, have incentives
to shift risks to depositors, as in a world of limited liability they only participate in the up-side part of this risk
taking. In a more competitive environment with more pressure on profits, banks have higher incentives to take
more excessive risks, resulting in higher fragility. On the other hand, in systems with restricted entry and there-
fore limited competition, banks have better profit opportunities, capital cushions and therefore fewer incentives
to take aggressive risks, with positive repercussions for financial stability. In addition, in a more competitive
environment, banks earn fewer informational rents from their relationship with borrowers, reducing their in-
centives to properly screen borrowers, again increasing the risk of fragility (?, ?, ?). The competition-stability
hypothesis, on the other hand, argues that more competitive banking systems result in more, rather than less,
stability. Specifically, ? show that lower lending rates reduce the entrepreneurs’ cost of borrowing and increase
the success rate of entrepreneurs’ investments. As a consequence, banks will face lower credit risk on their
loan portfolio in more competitive markets, which should lead to increased banking sector stability. However,
more recent extensions of the ? model that allow for imperfect correlation in loan defaults (?; ?) show that the
relationship between competition and risk is U-shaped. Hence, the impact of an increase in competition can go
either way, depending on other factors and the existing intensity of competition.
7
6
For an excellent overview of the existing (pre-2008) models and empirical evidence on the relationship between competition and
stability, see ? and ?.
7
? extends the ? model and allows for risk choices made by borrowers as well as banks. If lending rates decline due to more
competition, banks have less to lose in case a borrower defaults. Hence, a bank may find it optimal to switch to financing riskier
projects, which overturns the ? results. Other authors have also shown that more intense competition may induce banks to (i) switch
to more risky, opaque borrowers (?), and (ii) acquire less information on borrowers (?). ? provide empirical evidence of a margin as
well as a risk effect. Exploiting exogenous variation in market contestability, they find that deregulation explains at least 10% of the
rise in bankruptcy rates. However, they also find that credit risk, measured as the loss rate on loans, decreases following deregulation.
Thus, while banks made more bad loans, which explains the increase in bankruptcies, the default risk among all borrowers fell. This
suggests that banks increased credit to both existing low risk customers as well as new, riskier ones, because of banks’ enhanced ability
4
