The Effect of Competition in Banking on the Stability of Banks

Banking is one of the most important sectors in each economy. Not only can it affect economic activities but it can also have impact on the stability of economies. Hence, the stability of banking needs a remarkable supervision. Accurses of crises in banking will rapidly grow in other real sectors in economy, because the other sectors refer to banks for acquiring finance resources. Recent economic research focused more on factors that might induce banks to take more risks. Competition is one of these factors. Competition is desirable for maximization of social welfare and existence of Pareto efficiency. As in other industries, competition in banking system is also needed for efficiency and maximization of social welfare. However, banking sector has specific features that make it of particular importance to an economy and properties that may distinguish it from other industries. For example, there is a strong interrelationship between banks and other industries.
Theoretical Framework: Economic theory provides an ambiguous answer to the question how bank competition, bank concentration, and financial stability are related. There are two views about the effect of competition in banking sector on bank's stability: Competition – Fragility (Concentration – Stability) view and Competition – Stability (Concentration – Fragility) view. On the one hand, competition reduces the market power of banks, which reduces the discounted value of the profit that banks are expected to earn in the future. This enhances the incentives for banks to take more risk, because the opportunity costs of going bankrupt are lower (Competition – Fragility). On the other hand, market power in the loan market allows banks to charge higher interest rates. This increases moral hazard and adverse selection, which increases the probability of failure of banks (Competition – Stability). Hence, this paper tries to test correctness of these two views.
The main purpose of this research is analyzing and evaluating the effect of competition in banking sector from 2005 to 2011. The most important variables of this research are bank stability as a function of market structure, control variables at bank level (loans on assets, size and returns on assets) and control variables at macroeconomic level (growth rate, economic freedom and inflation). In order to estimate this model, panel data method was used. When there are repeated observations in the same set of cross-section units, panel data technique is applied. Our model has balanced panel. That is, we have the same number of observations on each cross-section unit.
When a researcher wants to use panel data technique, he faces with three types of models, namely, pooled model, random effects model, and fixed effects model. The pooled estimation is the simplest case, which proceeds by essentially ignoring the panel structure of the data. Estimation of this model is straightforward. The assumptions we have made correspond to the classic linear model. Efficient estimation proceeds by stacking the data as already shown and using Ordinary Least Squares (OLS). The random effects model has this characteristic; individual effect is uncorrelated with explanatory variables. It is important to stress that the substantive assumption that distinguishes this model from the fixed effects model is that the time-invariant person specific effect is uncorrelated with independent variables. In essence, the random effects model is one way to deal with the fact that T observation on N individuals are not the same as observations on NT different individuals. The solution is straightforward. First, we derive an estimator of the covariance matrix of the error term. Second, we use this covariance structure in our estimator of parameters. While fixed effects model has this characteristic; individual effect is correlated with explanatory variables. Because the fixed effects model starts with this presumption, we must estimate the model conditionally on the presence of the fixed effects.
Our results show a significantly negative/positive relationship between competition (concentration) and bank's stability. Among the other variables, bank's assets has the most (significant) powerful effect on stability. Although this paper provides evidence for the competition – fragility hypothesis and the concentration – stability hypothesis, other studies need to be done to explore the mechanisms how competition and concentration in the banking sector affect financial stability. Furthermore, due to the rapid increase in financial interlink ages, measuring competition becomes harder because a single country might not be the relevant banking market.
Conclusion and Suggestion: Although this study provides evidence for the competition – fragility hypothesis and the concentration – stability hypothesis, other studies need to be done to explore the mechanisms through which competition and concentration in the banking sector affect financial stability. According to the results of this paper, the following suggestions are made for policy makers.
[1] Government and central bank should increase their supervision and control on banking.
[2] Policy makers must enact appropriate and effective rules on banks in which they regard minimum requirement of stability.