Bank competition policy has been a focus of much research and policy debate. The reason for this is the special nature of banks. In the non-financial sector, competition policy mainly focuses on efficiency (competitive pricing). Yet for banks there is another relevant dimension: systemic risk. When the degree of competition adversely affects banks’ risk-taking incentives, bank competition policy should have a macroprudential component.
The theoretical predictions and empirical results on the link between bank competition, risk-taking, and stability are ambiguous. But on net they suggest that an intermediate degree of bank competition is optimal. Too much competition erodes the charter values of banks and creates incentives for risk-taking. Too little competition reduces efficiency and may lead to the too-big-to-fail problem (Allen and Gale 2004, Beck 2008, Claessens 2009).
The traditional focus is on market structure – concentration
Traditional bank competition policy tries to establish an intermediate degree of competition though policies that focus on market structure – especially concentration:
- Entry/exit rules (for domestic and foreign banks).
- Consolidation of banks.
- Restrictions on activities of banks and non-banks.
And by policies that affect contestability in banking (competition given market structure), for example establishing credit registries or providing equal access to payments infrastructure.
But the focus on market structure may be misplaced
However, market structure had little bearing on bank performance during the Crisis. To see this, consider the scatter plot of bank performance (bank equity value loss) versus bank concentration (market share of top three banks) during the Crisis.
While one could detect some inverse U-shaped relationship predicted by the standard arguments (driven by positions of Canada and Australia – the countries least affected by the Crisis), such a relationship would have little economic significance. Banks from countries with similar concentrations were very differently affected by the Crisis (Canada, France and Ireland). Other factors – non-core exposures funded in wholesale markets (Germany and UK) and high leverage (Ireland or Germany) certainly played a larger role in explaining bank performance.
There are three reasons why market structure may not affect financial stability in the ways that the traditional literature leads us to expect:
- Progress in information technology increased the availability of ‘hard’ (quantifiable, verifiable) information on borrowers.
This reduced the grip that banks had over their customers thanks to ‘soft’ (proprietary) information accumulated in existing bank-customer relationships. As a result, today, banks may act competitively even in concentrated systems. High competition means low profits and structurally high incentives to take risk.
- Competition in the provision in financial services has become more international and cross-sectoral.
Foreign bank entry and cross-border flows affected bank profits and risk-taking incentives in countries such as Spain and Ireland. And in the US, non-banks (e.g. finance companies and independent mortgage originators) entered mortgage markets prior to the Crisis to compete with banks.
- Even when the relationship between market structure and bank stability is present, its properties are country-specific;
‘Optimal’ market structure depends on financial development, quality of regulation, etc. (Beck et al. 2013). This makes it hard to make a certain degree of bank concentration as a universal policy objective.
The weak link between market structure and bank risk-taking has been long recognised in the literature (Claessens and Laeven 2004; Demirguc-Kunt et al. 2004), but insufficiently so in policy debates.
How can bank competition policy support financial stability?
In a recent paper (Ratnovski, 2013), I examine new ways in which bank competition policy can support financial stability. My analysis suggests three priorities:
- First, help address ‘too-big-to-fail’.
The too-big-to-fail problem is a major prudential concern (Haldane 2013). The Basel III capital surcharges for systemically important banks (up to 2.5% of risk-weighted assets) might be too small to give banks incentives to shrink. Bank competition policy can help address too-big-to-fail.
A blunt approach would be to use competition-policy tools to directly restrict bank size (by limiting mergers, forcing spin-offs, etc.). However it may be hard to restrict size on competitive grounds when banking is contestable and efficient. And since we do not know much about optimal bank size, blunt restrictions may have unintended effects.
A more nuanced approach would be price-based. Competition in banking is distorted because large banks have access to cheaper funding than small banks (thanks to the too-big-to-fail guarantee, as much as 80 basis points cheaper; Ueda and Weder di Mauro 2012). Levelling the playing field is a natural area for competition policy. The funding advantage of too-big-to-fail banks can be offset through equivalent taxes or fines (think of a tax on wholesale funding of banks, with a rate that is increasing in bank size). This competition policy measure, as a by-product, would reduce excess incentives for banks to grow, reducing the too-big-to-fail problem.
- Interaction with structural policies.
Recent structural policy initiatives aim to restrict bank or non-bank activities that contribute to systemic risk (Gambacorta and van Rixtel 2013). These limits would have important interactions with competition policy.
The Volcker Rule and the Vickers and Liikanen proposals suggest restricting market-based and, to an extent, international activities of banks. The rationale is that such activities may contribute disproportionately to systemic risk (Boot and Ratnovski 2013). From a competition perspective, these restrictions might also be desirable. They would allow authorities to use different approaches to less contestable (core) and more contestable (market-based and international) sectors of banking, resulting in a more precise competition policy.
Another structural problem highlighted by the Crisis is excess competition for retail deposits. Retail deposits are the most stable source of bank funding (Huang and Ratnovski 2009). When deposits are scarce, banks have to rely on unstable wholesale funding. A common reason for the scarcity of deposits is excess competition for household savings – from insurance companies or asset managers (as in Australia or the Nordics) or from local savings banks with implicit public guarantees (as in Germany). Competition policy may help by pressuring governments to level the playing field – deal with implicit guarantees and lax regulation of non-banks.
- Competition policy and crisis management.
The Crisis put into sharp relief possible conflicts between bank competition policy and crisis management (Vickers 2010). Normally, competition policy advocates limited government involvement in banks in order to maintain a level playing field. Yet, crisis management may require governments to take ownership in banks or offer banks guarantees in order to maintain financial stability and the capacity to lend. Also, governments may need to exercise control over banks to direct their restructuring.
In such exceptional circumstances, competition policy should acknowledge the trade-off between preserving the level playing field versus effective bank resolution, and aim for a balance. Also, competition policy might need to temporarily allow higher banking-system concentration, when that is necessary to allow banks to rebuild charter values or to facilitate the shrinking of a previously over-expanded banking-system.
Disclaimer: The views expressed here are those of the author and do not represent those of the institutions with which he is affiliated.
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Beck, T (2008), “Bank Competition and Financial Stability: Friends or Foes”, World Bank Policy Research Working Paper 4656.
Beck, T, O De Jonghe and G Schepens (2013), “Bank Competition and stability: Cross-country heterogeneity”, Journal of Financial Intermediation, forthcoming.
Boot, Arnoud and Lev Ratnovski (2012), “The risks of trading by banks”, VoxEU.org, 8 October.
Claessens, S, and L Laeven (2004), “What Drives Bank Competition? Some International Evidence”, Journal of Money, Credit, and Banking 36(3), 2, 563-83.
Claessens, S (2009), “Competition in the Financial Sector: Overview of Competition Policies”, IMF Working Paper 09/45.
Demirgüç-Kunt, A, L Laeven, and R Levine (2004), “Regulations, Market Structure, Institutions, and the Cost of Financial Intermediation”, Journal of Money, Credit, and Banking, 36(3), 2, 593-622.
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Haldane, Andrew G (2013), “Have we solved ‘too big to fail’?”, VoxEU.org, 17 January.
Huang, Rocco and Lev Ratnovski (2013), “Why are Canadian banks more resilient? And what can we do about risky wholesale funding?”, VoxEU.org, 15 August.
Ratnovski, L (2013), “Competition Policy for Modern Banks”, IMF Working Paper 13/126.
Ueda, K and B Weder di Mauro (2012), “Quantifying Structural Subsidy Values for Systemically Important Financial Institutions”, IMF Working Paper 12/128.
Vickers, J (2010), “Central Banks and Competition Authorities: Institutional Comparisons and New Concerns”, BIS Working Paper 331.