The Consequences Of Competition In The Banking Industry

It has been widely argued that competition in the banking industry has indisputable effect on financial stability and economic growth (Allen and Gale, 2004; Claessens and Laeven, 2004; Northcott, 2004). However, the impact on efficiency and stability is not always positive (Allen and Gale, 2004). A large and growing body of literature is attempting to identify the optimal level of banking competition with regards to the above considerations. It has been argued that on the one hand, higher competition leads to a more efficient financial system and furthermore, to economic growth (Allen and Gale, 2004; Northcott, 2004). On the other hand, market power or monopoly is necessary for stability in the banking industry (Northcott, 2004). The purpose of the following paragraphs is to assess the implications of competition in the banking industry by critically discussing both theoretical and empirical works on the topic.

Theoretical models of competition in the banking industry:

Theoretical literature on competition in the banking industry usually employs the traditional industrial organisation approach to banking in order to identify the effects of increased competition in the sector. According to Monti-Klein model, a monopoly bank, representing the banking industry as a whole, is facing a downward sloping demand for loans and upward sloping supply of deposits (Freixas and Rochet, 2008). The bank is making profit equal to the difference between the intermediation margins on deposits and loans and the management costs (Freixas and Rochet, 2008). The implication of this model is that intermediation margin is reduced as soon as firms and households get access to substitute products in the financial market and the optimal deposit and loan interest rates are set independently of each other (Freixas and Rochet, 2008).

At the other extreme is the perfect competition model of banking industry, where the bank is a price taker and equates the intermediation margin to the marginal management costs (Freixas and Rochet, 2008). The consequence of a decrease in the deposit rate is a decrease in the demand for deposits and respectively, an increase in the loan rate implies an increase in the supply of loans (Freixas and Rochet, 2008).

The perfect competition model of banking industry is not realistic due to the presence of considerable barriers to entry, switching costs and information asymmetries (Vives, 2001). Therefore, an oligopolistic model with a finite number of banks is employed in which the deposit and loan rates depend on the number of banks and the intermediation margin is lowered by an increase in the number of banks in the industry (Freixas and Rochet, 2008). Therefore, when competition in the banking industry intensifies profits realised from the difference between deposit and loan rates is reduced (Matthews and Thompson, 2005).

Banking competition and macroeconomic performance:

Theoretical models discussed above suggest that increased competition in the banking industry has direct consequences for both the loan and deposit rates by decreasing rates charged on loans and increasing the return for depositors (Besanko and Thakor, 1992, cited in Northcott, 2004, p.4). Apart from that, competition affects macroeconomic performance in terms of economic activity and financial stability.

A number of studies have found that there is a positive relationship between competition in the banking industry and economic growth. In an attempt to explain this relationship, Guzman (2000) demonstrates that a monopoly banking system impedes capital formation. This is due to the fact that a monopoly bank is more likely to ration credit and charge either higher loan rate or pay lower deposit rate which increases the rate margin and causes slower rate of economic activity (Guzman, 2000). Smith (1998) employs a theoretical model in order to demonstrate that increased competition in the banking sector drives loan and deposit rates down which on its turn influences macroeconomic performance by enhancing capital accumulation and alleviating the “severity of business cycles”.

It has been argued that increased competition leads to better allocative efficiency by ensuring that credit is supplied at the lowest price, whereas in concentrated markets, a bank makes profit by supplying less credit at higher interest rates (Northcott, 2004; Vives, 2001). Although there are general arguments in favour of competition, this view has been challenged in a couple of respects. Considering the adverse selection problem in banking, Broecker (1990) develops a model of competition between banks applying screening tests in order to assess the credit-worthiness of borrowers. The increase in the number of banks is beneficial for economy only when tests are effective and generate fail results for all bad borrowers (Broecker, 1990). However, more competition and the two-stage screening process increase the chance for bad firms to be financed which in turn, worsens allocation efficiency (Broecker, 1990). Monopoly in the banking industry increases the screening standards helping the efficient allocation of resources (Northcott, 2004).

Furthermore, market power encourages banks to invest more in relationship banking (Peterson and Rajan, 1995). In line with this view, Paterson and Rajan (1995) empirically prove that young firms have greater access to lower cost finance in a monopoly banking conditions rather than in a competitive banking environment. The authors suggest that this is due to the expectations of the bank to obtain grater share of the firm’s future return instead of charging high interest rates in the first period.

Competition and financial stability:

Even though theoretical and empirical evidence suggest that competition in the banking industry is good for economic growth, there is a view that market power in this sector is crucial for financial stability (Keeley, 1990; Allen and Gale, 2004). Since competition leads to lower margins (Bolt and Tieman, 2004), banks with greater market power and higher profits respectively, tend to behave in a more conservative way (Vives, 2001). More competition creates incentives for banks to invest in riskier projects which on its part increase their default risk and the probability of bank failures (Keeley, 1990; Vives, 2001).

In an attempt to attract more borrowers and to increase its assets, a bank in a competitive environment sets lower acceptance criteria which attract potentially bad loan applicants and deteriorate bank’s portfolio (Bolt and Tieman, 2004). Therefore, regulation of the banking sector is necessary in order to ensure that the excessive risk taking will not lead to bankruptcy (Bolt and Tieman, 2004). It is argued that regulation of the banking industry by imposing higher barriers to entry restricts competition and reduces to great extent allocation efficiency (Jayaratne and Strahan, 1996). On the other hand, according to Jayaratne and Strahan (1996), the removal of branching restrictions intensifies competition and improves bank performance by allowing greater efficiency.

Keeley (1990) empirically demonstrates that a riskier behaviour and moral hazard problems are typical for banks in a competitive environment and in the presence of fixed rate deposit insurance. Vives (2001) suggests that risk-based insurance premium is a way to reduce levels of risk taken by banks. However, fair pricing of a premium is not possible without perfect information (Chan et al., 1992, cited in Freixas and Rochet, 2008).

A final aspect of competition in the banking industry is the probability of failure and financial instability. A theoretical model of banking crisis, developed by Boyd et al. (2004), demonstrates that competition in the banking industry is likely to increase the probability of a crisis in the sector only if the nominal interest rate is above a particular level, i.e. when the rate of interest is high, a monopoly bank offers lower return on deposits that are withdrawn early and in this way faces lower probability of “reserve exhaustion”. However, the cost of such a crisis is significantly higher under competition due to the fact that banks with market power have incentives to withhold the liquidation of storage investments in order to prevent an immediate fall in their profitability (Boyd et al., 2004).

The discussion in the above paragraphs leads to the conclusion that competition in the banking industry has contradictory consequences. On the one hand, increased competition drives prices down, allows the access to lower cost finance and improves the efficient allocation of resources. All these effects contribute to greater capital formation and increased rate of economic growth. On the other hand, market concentration or monopoly is a better prerequisite for a stable financial system, also known as a trade-off between competition and financial stability (Freixas and Rochet, 2008). However, by regulating the banking industry the consequences of risk-taking under perfect competition are moderated and the incentives to monitor borrowers created under monopoly improve allocative efficiency (Northcott, 2004). In the aftermath of the recent financial crisis there is a trend towards tighter regulation and an increase in the number of merger and acquisitions in the banking industry, especially in the USA (Schildbach, 2009). Both of these lead to less competition and aim at improving the financial stability of the country.