Bank Concentration, Competition, and Crises:
First results
Thorsten Beck, Asli Demirgüç-Kunt and Ross Levine
First Draft: December, 2002
This Draft: May 2005
Abstract: Motivated by public policy debates about bank consolidation and conflicting
theoretical predictions about the relationship between bank concentration, bank competition and
banking system fragility, this paper studies the impact of national bank concentration, bank
regulations, and national institutions on the likelihood of a country suffering a systemic banking
crisis. Using data on 69 countries from 1980 to 1997, we find that crises are less likely in
economies with more concentrated banking systems even after controlling for differences in
commercial bank regulatory policies, national institutions affecting competition, macroeconomic
conditions, and shocks to the economy. Furthermore, the data indicate that regulatory policies
and institutions that thwart competition are associated with greater banking system fragility.
Keywords: Banking System Fragility, Industrial Structure, Regulation
JEL Classification: G21, G28, L16
Beck and Demirgüç-Kunt: World Bank; Levine: Carlson School of Management, University of Minnesota and the
NBER. We thank two anonymous referees, John Boyd, Jerry Caprio, Maria Carkovic, Patrick Honohan and
participants in the World Bank Concentration and Competition Conference for comments and Paramjit K. Gill, Lin
Li and April Knill for outstanding research assistance. This paper’s findings, interpretations, and conclusions are
entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors,
or the countries they represent.
I. Introduction
The consolidation of banks around the globe is fueling an active public policy debate on
the impact of consolidation on financial stability.
1
Indeed, economic theory provides conflicting
predictions about the relationship between the concentration and the competitiveness of the
banking industry and banking system fragility. Motivated by public policy debates and
ambiguous theoretical predictions, this paper investigates empirically the impact of bank
concentration and bank regulations on banking system stability.
Some theoretical arguments and country comparisons suggest that a less concentrated
banking sector with many banks is more prone to financial crises than a concentrated banking
sector with a few banks (Allen and Gale, 2000, 2004). First, concentrated banking systems may
enhance market power and boost bank profits. High profits provide a “buffer” against adverse
shocks and increase the charter or franchise value of the bank, reducing incentives for bank
owners and managers to take excessive risk and thus reducing the probability of systemic
banking distress (Hellmann, Murdoch, and Stiglitz, 2000; Besanko and Thakor, 1993; Boot and
Greenbaum, 1993, Matutes and Vives, 2000).
2
Second, some hold that it is substantially easier
to monitor a few banks in a concentrated banking system than it is to monitor lots of banks in a
diffuse banking system. From this perspective, supervision of banks will be more effective and
the risks of contagion and thus systemic crisis less pronounced in a concentrated banking system.
According to Allen and Gale (2000), the U.S., with its large number of banks, supports this
1
See Group of Ten (2001), Bank for International Settlements (2001), International Monetary Fund (2001). See
Carletti and Hartmann (2003) and Boyd and De Nicoló (2005) for an overview of the literature.
2
Rather than focusing on the links between concentration and the portfolio decisions of banks, Smith (1984) holds
banks’ asset allocation decisions constant and examines the liquidity side of the balance sheet. He shows that less
competition can lead to more stability if information about the probability distribution of depositors’ liquidity needs
1
“concentration-stability” view since it has had a history of much greater financial instability than
the U.K or Canada, where the banking sector is dominated by fewer larger banks.
3
An opposing view is that a more concentrated banking structure enhances bank fragility.
First, Boyd and De Nicolo (2005) argue that the standard argument that market power in banking
boosts profits and hence bank stability ignores the potential impact of banks’ market power on
firm behavior. They confirm that concentrated banking systems enhance market power, which
allows banks to boost the interest rate they charge to firms. Boyd and De Nicolo’s (2005)
theoretical model, however, shows that these higher interest rates may induce firms to assume
greater risk. Thus, in many parameterizations of the model, Boyd, and De Nicolo (2005) find a
positive relationship between concentration and bank fragility and thus the probability of
systemic distress. Similarly, Caminal and Matutes (2002) show that less competition can lead to
less credit rationing, larger loans and higher probability of failure if loans are subject to
multiplicative uncertainty. Second, advocates of the “concentration-fragility” view argue that (i)
relative to diffuse banking systems, concentrated banking systems generally have fewer banks
and (ii) policymakers are more concerned about bank failures when there are only a few banks.
is private. Matutes and Vives (1996), however, highlight the complexity of the linkages running from market
structure, to competition, to bank stability and show that bank fragility can arise in any market structure.
3
Some proponents of the “concentration-stability” view argue that -- holding other things constant – (i) banks in
concentrated systems will be larger than banks in more diffuse systems and (ii) larger banks tend to be better
diversified than smaller banks. Based on these assumptions, concentrated banking systems with a few large banks
will be less fragile than banking systems with many small banks. Models by Diamond (1984), Ramakrishnan and
Thakor (1984), Boyd and Prescott (1986), Williamson (1986), Allen (1990), and others predict economies of scale
in intermediation. As discussed by Calomiris (2000) and Calomiris and Mason (2000), an extensive literature finds
an inverse relationship between bank scale and bank failure in the United States. However, empirical work by
Chong (1991) and Hughes and Mester (1998) indicates that bank consolidation tends to increase the riskiness of
bank portfolios. Boyd and Runkle (1993), examining 122 U.S. bank holding companies, find that there is an inverse
relationship between size and the volatility of asset returns, but no evidence that large banks are less likely to fail.
De Nicoló (2000), on the other hand, finds a positive and significant relationship between bank size and the
probability of failure for banks in the U.S., Japan and several European countries. Further, in a concentrated banking
system, the contagion risk of a single bank failure could be more severe, resulting in a positive link between
concentration and systemic fragility. Thus, there are open issues regarding the relationship between bank size and
bank risk. Although we explore the sensitivity of our results to controlling for the mean bank size in each country,
this paper examines the relationship between bank concentration, bank regulations, and crises, not the relationship
between bank size and diversification.
2
Based on these assumptions, banks in concentrated systems will tend to receive larger subsidies
through implicit “too important to fail” policies that intensify risk-taking incentives and hence
increase banking system fragility (e.g., Mishkin, 1999).
4,
5
Despite conflicting theoretical predictions and policy debates, there is no cross-country
empirical evidence on bank concentration, bank competition and the incidence of systemic
banking failures. For the U.S., Keeley (1990) provides evidence that increased competition
following relaxation of state branching restrictions in the 1980s resulted in an increase in large
banks’ risk profiles. Jayaratne and Strahan (1998), on the other hand, find that deregulation in
the 1980s resulted in lower loan losses, while Dick (2003) finds higher loan loss provisions
following deregulation in the 1990s. On the cross-country level, De Nicoló et al. (2003) relate
bank concentration to the fragility of the largest five banks in a country and find a positive
relationship, suggesting that bank concentration leads to more bank fragility. They do not
consider the incidence of systemic banking distress.
Using data on 69 countries over the period 1980-1997, this paper provides the first cross-
country assessment of the impact of national bank concentration, bank regulations, and national
4
There is a literature that examines deposit insurance and its effect on bank decisions. According to this literature
(e.g. Merton (1977), Sharpe (1978), Flannery (1989), Kane (1989), Keeley (1990), Chan, Greenbaum and Thakor
(1992), Matutes and Vives (2000) and Cordella and Yeyati (2002)) – mis-priced deposit insurance produces an
incentive for banks to take risk. If the regulatory treatment were the same for insured banks of all sizes, these
models would predict no relationship between bank size and riskiness. Since regulators fear potential
macroeconomic consequences of large bank failures, most countries have implicit “too large to fail” policies which
protect all liabilities of very large banks whether they are insured or not. Thus, the largest banks frequently receive
a greater net subsidy from the government (O’Hara and Shaw, 1990). Even in the absence of deposit insurance,
banks are prone to excessive risk-taking due to limited liability for their equity holders and to their high leverage
(Stiglitz, 1972). This subsidy may in turn increase the risk-taking incentives of the larger banks. For an analysis of
the corporate governance of banks, see Macey and O’Hara (2003).
5
Proponents of the concentration-fragility view would also disagree with the proposition that a concentrated
banking system characterized by a few banks is easier to monitor than a less concentrated banking system with
many banks. The countervailing argument is as follows. Bank size is positively correlated with complexity so that
large banks are harder to monitor than small banks. Holding all other features of the economy constant,
concentrated banking systems tend to have larger banks. Thus, this argument predicts a positive relationship
between concentration and fragility. Again, this paper focuses on the aggregate relationship between bank
concentration and crises. Although we control for bank size in our regressions, we do not examine the linkages
between bank size and the ease of monitoring.
3
institutions on the likelihood of a country suffering a systemic banking crisis.
6
While defined
more rigorously below, a systemic banking crisis refers to an episode when the entire national
banking system has suffered sufficient losses such that non-performing loans exceed ten percent
of total banking system assets, or when the government has taken extraordinary steps, such as
declaring a bank holiday or nationalizing much of the banking system. Besides the relationship
between systemic banking crises and concentration, we also examine international differences in
bank capital regulations, rules restricting bank entry, regulatory restrictions on bank activities,
and the overall institutional environment. While we use cross-country differences in these bank
regulations and institutions to assess the robustness of the relationship between concentration and
crises, the results on regulations and institutions are independently valuable. Specifically, we
provide empirical evidence on which regulations and institutions are associated with bank
stability.
The bulk of the evidence indicates that crises are less likely in more concentrated banking
systems, which supports the concentration-stability view. The negative relationship between
concentration and crises holds when conditioning on macroeconomic, financial, regulatory,
institutional, and cultural characteristics and is robust to an array of sensitivity checks. The data
never support the concentration-fragility view. Furthermore, our analyses suggest that the
relationship between concentration and crises is not driven by reverse causality. While we
cannot confirm or reject these results when restricting our sample to the high-income countries –
not surprising given the limited number of countries and crises – the significant, negative
6
Demirgüç-Kunt, Laeven and Levine (2004) investigate the impact of bank concentration and regulations on bank
net interest margins, but they do not examine bank fragility. Earlier work on systemic banking instability has mostly
focused on identifying (i) the macroeconomic determinants of banking crises (Gonzalez-Hermosillo, et al., 1997;
Demirgüç-Kunt and Detragiache, 1998, henceforth DD), (ii) the relationship between banking and currency crises
(Kaminsky and Reinhart, 1999), (iii) the impact of financial liberalization on bank stability (DD, 1999), and (iv) the
impact of deposit insurance design on bank fragility (DD, 2002). Barth et al. (2004) examine the relationship
between bank regulations and crises, but they do not examine bank concentration.
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