Banking competition vs stability
Does competition among banks lead to instability? The main assumption is that it does not because competition can spur improvements in the screening of potential borrowers, the governance of funded projects, and the management of bank risk. But what if competition squeezes profits, and as result encourages bankers to make riskier investments? This is the question Corbae and Levine explore in this paper. They develop a dynamic model of the banking system with i) differing degrees of executive myopia, defined as the executives’ focus on the short-term; ii) an endogenous structure of the banking sector where new banks emerge when bank owners expect that entry is profitable; and iii) a “monetary” policy defined as an exogenous change in the marginal cost of funds. Their findings include:
Regulatory reforms that facilitate competition (a) lower interest margins as banks compete for clients on both sides of the balance sheet, (b) spur financial innovations that improve banking services, and (c) induce banks to become more transparent as they compete in capital markets to issue securities. These last findings – that competition fosters innovation and transparency – can mitigate the long-run impact of competition on fragility, but they do not reverse the result that a regulatory-induced intensification of competition has a net, negative impact on banking system stability.
They suggest for policymakers to enhance bank governance and tighten leverage requirements to mitigate the fragility repercussions of lowering barriers to competition.
Competition, Stability, and Efficiency in the Banking Industry
Authors: Dean Corbae, Ross Levine
From: University of Wisconsin – Madison, University of California, Berkeley
What are the advantages of a highly concentrated banking sector?
The prevailing assumption is that high concentration in the banking sector raises concerns that large banks in concentrated systems are “too big to fail”, giving rise to moral hazard and excessive risk taking due to an implicit government backstop.
In this paper, Baron et al. build a new data set of the annual balance sheets of individual commercial banks since 1870 across 17 advanced economies, comprising more than 11,000 individual banks and more than 216,000 bank-year observations. Their aim is to study credit cycles and banking crises at the individual bank level over a long time. Their data show:
- The average share of banking sector assets in a given country held by the largest 5 banks has doubled from 35-40% in the 19th century to more than 70% today. The increase is strongest in countries like the United States that started with a highly fragmented banking system and now have a concentrated banking system;
- Persistence of large banks is very high. A bank among the largest five in a country is likely to remain one of the top-5 banks ten, fifty, or even over one hundred years later. In particular, 37% and 49% of banks that were in the top-5 by country in 1880 or 1910, respectively, remain a top-5 bank today.
- Large banks are more pro-cyclical, more risk-taking, and more prone to boom-bust dynamics. In post-1945 credit booms that precede banking crises, the top-5 banks account for nearly 80% of credit growth during the boom and for 80% of the credit contraction during and after the crisis;
But:
Top-5 banks are considerably less likely to fail. One likely explanation of the reduced failure rate compared to banks outside the top 5 is implicit guarantees or government assistance that prevent creditor runs. The paradoxical finding is that even though large banks tend to have much more pronounced solvency issues, they tend to survive at a substantially higher rate, which likely helps explain the high persistence of top 5 banks described above. Top-5 banks also tend to acquire a substantial number of other smaller failing banks during crises, who might not be protected by implicit guarantees, the net result of which is that the market dominance of the top-5 banks increases after crises.
Survival of the Biggest: Large Banks and Crises since 1870
Authors: Matthew Baron, Moritz Schularick, Kaspar Zimmermann,
From: Cornell University, University of Bonn, Leibniz Institute for Financial Research
