As mentioned above there are two opposing theories on the impact of banking competition on the stability of the financial system, namely the competition–fragility hypothesis and the competition-stability hypothesis. The competition–fragility theory sees competition in banking as detrimental to the financial system as it destabilises the sector. The competition- stability view however argues that an uncompetitive banking sector breeds fragility in the financial system and hence competition policy is required to minimise such fragility and stabilise the sector.
The key argument of the competition-fragility school is that competition among banks adversely affects their net interest margins and profitability due to increases in deposit rates and cuts in lending rates. As profits are eroded, banks are pushed into taking excessive risks to help maintain their profitability levels. Such excessive risk-taking behaviour by banks include imprudent lending behaviour, poor screening of potential clients and projects, loosening credit standards, extending lower quality loans, and financing riskier projects (Boot and Thakor, 1993; Cetorelli, 2001) . The risky behaviour of banks makes them vulnerable to high loan default rates, thereby potentially creating instability in the financial system. Risk is considered as endogenously determined by the bank and competition is accordingly seen as inducing fragility in the financial system through higher loan default, bank losses and equity erosion. Conversely, in less competitive banking environments, it is argued that banks’ net interest margins and profitability are usually not under threat, and so banks behave more
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prudently and have no incentives to engage in any risky ventures. Hence the threat to stability is muted in such uncompetitive banking environments (Keeley, 1990; Allen and Gale, 2000).
Competition–stability theorists on the other hand point to the fact that lack of banking competition tends to create a concentrated market structure in which large banks do exploit customers by charging higher lending rates.17 The high lending rates constrain the capability of borrowers to service their loans, exacerbate moral hazard incentives of borrowers to shift to riskier projects which increases credit default risk of borrowers, and thereby make the banking system susceptible to instability. Risk as a consequence is seen as exogenous to the bank since it is determined by the behaviour of the borrowers. The higher interest rates could also lead to problems of adverse selection of riskier borrowers (Boyd and Nicoló, 2005). Increased competition in this context by lowering lending rates makes loan repayment more affordable to borrowers and accordingly minimises bank default risks and any potential risky behaviour by borrowers, thereby reducing any threat of instability. Thus, the competition- stability view predicts that bank actions will result in more risk-taking and greater fragility in less competitive banking systems than in competitive banking environments, and thus competition policy is required to foster stability.
The two theories thus both see credit risk as the key channel through which instability enters the financial system. In the competition-fragility hypothesis this risk is endogenous while in the competition-stability hypothesis, it is exogenous.
Beside the above key arguments, there are other transmission mechanisms through which competition leads to fragility or stability. According to the competition-fragility theorists for example, a competitive banking sector, characterised by a large number of relatively small banks, is prone to instability due to the fact that small banks have a greater incentive to undertake risky behaviour (Allen and Gale, 2000). Such risky behaviour can have contagion effects in the banking sector. A concentrated banking sector with larger banks is therefore seen as inherently more stable because of the ability of larger banks to spread risks. The counter argument by competition-stability is that the contagion effect of a relatively small bank in a competitive banking environment is less pronounced than the contagion effect of a large bank which goes burst in a highly uncompetitive banking system.
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Although these arguments seem to link banking competition to a non-concentrated banking market, it has been shown that concentration measures are not necessarily good proxies for competition from both theoretical and empirical viewpoints (Liu et al., 2013). In particular, there could high competition in a highly concentrated banking industry, while competition could be low even in an industry with many banks and low concentration. This distinction between concentration and competition is important and explains why the structure-conduct performance model which relates competition to concentration has been widely discarded in recent empirical work as discussed later in this chapter.
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Another channel proposed by competition-fragility theory is that since a more concentrated and uncompetitive banking system tends to have a few large banks, it is easier to monitor and supervise such banks. The reduced supervisory burden could enhance the quality of supervision, and help foster stability of the banking system. On the contrary, a competitive market with many small banks makes supervision burdensome and ineffective, and could adversely affect financial stability (World Bank, 2012). Proponents of competition-stability counter this argument by indicating that this is not the case as larger banks in a concentrated market can be more complex and diversified, and hence more difficult to monitor and supervise than small banks.
Earlier work in support of the competition-fragility view includes Keeley (1990); Hellmann, Murdock, and Stiglitz (2000); and Allen and Gale (2000). In a study of the US banking sector, Keeley (1990) attributes the surge in bank failures in the US during the 1980s to intense competition which reduced monopoly rents and profit margins, and caused banks to engage in excessive risky behaviour with the view to maintaining profitability levels. The paper observes that prior to the 1980s, regulatory restrictions on bank entry and branching as well as other anti-competitive measures made banks profitable and bank charters valuable. Thus banks had an incentive not to engage in risky behaviour. The relaxation of regulatory controls and pursuit of deregulation policies in the 1980s, led to declining profitability and bank charter values due to increased competition. Thus, increased competition reduced incentives for prudent bank behaviour and led to excessive risk-taking which contributed to bank failures during the 1980s.
Hellmann et al. (2000) also attribute the crisis in the US Savings and Loans market as well as the Japanese crisis to excessive risky behaviour by banks following the deregulation policies of relaxation of restrictions to bank branching and bank entry as well as deregulating interest rates. Increased competition in the deposits market led to higher deposit rates which caused banks’ profitability to be under pressure and led to a reduction of their charter or franchise values, fuelling moral hazard in their behaviour.
At the other end of the spectrum, and using a panel data set of 69 countries over the period 1980–1997, Beck, Demirgüç-Kunt, and Levine (2006) establish that greater bank concentration is associated with a lower likelihood of suffering a systemic banking crisis. Their result is consistent with the concentration-stability, with the negative relationship between concentration and crises found to be robust. An interesting observation by the paper is that they find no evidence that banking system concentration is a proxy for a less
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competitive banking environment. This is crucial as the theories presume that a concentrated market is a sign of uncompetitiveness or that the presence of a large number of banks in a banking sector is synonymous with intense competition which may not be the case. The authors however find support that concentrated banking systems have larger, better diversified banks with a correspondingly lower probability of failure, but no evidence that they are easier to monitor and hence more stable than less concentrated banking systems (Beck et. al., 2006).
Schaeck, Cihak, and Wolfe (2009), in a cross-country study of the relationship between competition and banking system fragility find support for the competition–stability view. The paper establishes that more competitive banking systems are less prone to systemic crises than less competitive banking systems. The results suggest that competitive behaviour of financial institutions not only significantly decreases the probability of systemic banking risk but also increases the survival time of banking systems. Based on various specification models they find no empirical support for the competition–fragility theory.
Ariss (2010) investigates how different degrees of market power affect efficiency and bank stability in a cross-country study of 821 banks in 60 developing countries over the period 1999-2005.18 The paper establishes that an increase in the degree of market power leads to greater bank stability and reduces risk potential, in support of the competition-fragility theory. The paper notes that the findings could provide a rationale for the growth in mergers and acquisitions of banks in developing countries. The paper opines that increased market power may be a welcome development as it will facilitate financial stability in the relative stressed banking sectors in most developing countries in general.
For African countries, Moyo, Nandwa, Council, Oduor, and Simpasa (2014) explore the competition-stability-fragility nexus in a cross-country study of 16 African countries during 1995–2010, and the role macroeconomic and institutional factors play in the relationship. Specifically, the study examines the proposition that increased competition in the banking sector resulting from financial liberalization enhances financial stability. The results show that financial liberalization enhanced competition in Africa’s banking sector, and that increased competition in the post liberalisation period corresponded to higher lead times to bank distress episodes. Their result is therefore in support of the competition-stability theory. The authors note, however, that stability of Africa’s banking system in a liberalized and competitive
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The developing countries are from Africa, East/South Asia & Pacific, Eastern Europe and Central Asia, Latin America & Caribbean and the Middle East.
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environment is contingent on the pursuit of sound macroeconomic policies and strong institutional support to enable the banking sector thrive.
The review of the empirical literature across different regions clearly shows that the relationship between competition and stability is neither clear-cut nor conclusive. This observation is also noted by Carletti and Hartmann (2003), who opine that the theoretical literature on competition-stability is not conclusive, as theories of bank runs and systemic risk largely disregard the implications of different bank market structures for the safety of the financial sector. The authors also contend that while some empirical work support the influential ‘charter value’ hypothesis of a negative relationship between competition and bank stability, others do not, and therefore conclude that the stability effects of changes in market structures and bank competition are case-dependent, and therefore require different institutional approaches to address them in different countries.
Another important consideration in this debate is that both competition and risk are measured in very different ways across the empirical work, which might partly explain the contradictory results. Different measures of bank competition (concentration ratios, Panzar-Rosse H- statistic, Lerner Index, etc.) can lead to different outcomes as we discuss in Section 3.4. Similarly, different measures of risk and fragility (non-performing loans, z-score, systemic risk, etc.) have different implications for stability. In addition, while some studies define fragility in terms of individual bank risk others define it in terms of the co-dependence of those risks, that is, systemic risk (Anginer, Demirgüç-Kunt, and Zhu, 2013).
The global financial crisis during 2007/8 reignited the debate on the competition- stability/fragility nexus and the design of pro-competition policies, that is, regulatory and deregulatory policies that influence the way and extent to which banks compete. Some believe that increases in banking competition and financial innovation led to distortions such as subprime lending, thus contributing to financial instability and crisis. However, others contend that the assertion that competition increased before the crisis does not necessarily suggest that greater competition in itself spurred the crisis. Beck (2008) observes that notwithstanding the conflicting empirical results, banking system fragility arising from increased competition is mostly the consequence of regulatory and supervisory failures, rather than competition per se. Thus, the benefits of increased competition for an efficient and inclusive financial system are strong, and regulatory and supervisory policies should focus on an incentive compatible environment for banking rather than try to fine-tune market structure or the degree of competition. This view is shared by Anginer et al. (2013) who suggest that
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supervisory lapses and inadequate risk management supervision contributed to the crisis, rather than increased competition, as the financial crisis was preceded by an increase in market power.
In a more recent study, Beck, De Jonghe, and Schepens (2013) provide further empirical evidence which suggests that the relationship between competition and stability varies across different countries with different regulatory frameworks, market structures and levels of institutional development. While the authors show, on average, a positive relationship between banks’ market power and banks’ stability, an increase in competition is associated with a larger rise in banks’ fragility in countries with stricter activity restrictions, lower systemic fragility, better developed stock exchanges, more generous deposit insurance and more effective systems of credit information sharing.
In conclusion, the likely impact of increased competition in Ghana’s banking sector on financial stability is an empirical question that ought to be examined. The paper by Moyo et al. (2014) however argues that competition following deregulation or financial liberalisation in African banking sectors fosters stability if underpinned by macroeconomic environment and strong regulatory and institutional capacity. Most African banking sectors have been generally stable. Financial soundness indicators in most African countries point to relatively stable banking sectors with high liquidity, profitability and capital adequacy ratios. High capital to risk-weighted asset ratio averaging 19% in Africa is higher compared to other developing countries and significantly higher than international benchmark rates (Beck & Cull, 2014), partly due to the huge investment by banks in government securities, with moderate investment in risky assets. In Ghana, banks have consistently exceeded the minimum capital to risk-weighted asset ratio of 10% set by the Central Bank, with the industry average of over 17% for the past six years (Bank of Ghana, 2014). These large values are the combinations of large minimum capital requirements introduced in 2009, and the fact that government treasury bills continue to be an attractive investment for banks notwithstanding the scrapping of the secondary reserves. The stability of the banking sector in recent times however is no guarantee that it will continue in the light of these financial liberalisation policy reforms especially in the face of macroeconomic shocks and weak institutions. We do not examine the competition-stability-fragility theories in this thesis, but have discussed the potential impact that competition can have on financial stability based on these theories. The expected impact of competition in enhancing banking stability or creating
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fragility for African countries, such as Ghana, with relatively less developed banking systems, is therefore an open empirical question, and one that needs to be explored in future research.