Bank Competition and Financial Stability

• Published in: Journal of financial services research 2009-04, Vol.35 (2), p.99-118
• Main Authors: Berger, Allen N., Klapper, Leora F., Turk-Ariss, Rima
• Format: Article
• Language: English
• Subjects: Adverse selection; Bank competition; Bank failures; Banking industry; Banking system; Banking system fragility; Banks; Capital and Ownership Structure G320; Competition; Economic stability; Economics and Finance; Equity capital; F30; Finance; Financial Risk and Risk Management; Financial Services; Financial stability; Financing Policy; Firm Performance: Size, Diversification, and Scope L250; G21; G38; Interest rates; L89; Loans; Macroeconomics/Monetary Economics//Financial Economics; Micro Finance Institutions; Monopolies; Moral hazard; Mortgages G210; Other Depository Institutions; Production, Pricing, and Market Structure; Ratios; Regulation; Regulation of financial institutions; Risk exposure; Size Distribution of Firms L110; Studies
• ISSN: 0920-8550; 1573-0735
• DOI: 10.1007/s10693-008-0050-7

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.