Are More Competitive Banking Systems More Stable

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Are More Competitive Banking Systems More Stable?
8th Conference of the ECB-CFS Research Network
on "Financial Integration and Stability in
Europe" 30th November 1st December, 2006, Bank
of Spain, Madrid
Klaus Schaeck University of Southampton
Martin Cihak International Monetary Fund
Simon Wolfe University of Southampton
DISCLAIMER This papers findings,
interpretations, and conclusions are entirely
those of the authors and do not necessarily
reflect the views of the International Monetary
Fund, its Executive Directors, or the countries
they represent.
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Are More Competitive Banking Systems More Stable?
Outline (1) Introduction (2)
Rationale/Contributions of this Research
(3) Methodological Approach (4) Econometric
Analysis (5) Sensitivity Tests and
Extensions (6) Conclusion and Future
Research
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Are More Competitive Banking Systems More Stable?
(1) Introduction

The extant literature is divided on whether
competition in banking contributes to stability
or leads to the build up of vulnerabilities. Comp
etition less stability Competition more
stability e.g. Smith (1984) e.g. Koskela and
Stenbacka (2000)
Lack of cross-country data on competitive
behavior made policymakers and researchers rely
on concentration as a proxy for
competition. Concentration less
stability Concentration more stability e.g.
Mishkin (1999) e.g. Boot and Greenbaum (1993)
Empirical studies also report contradictory
evidence. Concentration less stability Concentra
tion more stability e.g. De Nicoló et al.
(2004) e.g. Beck et al. (2006a, 2006b)
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(2) Rationale

• Relying on concentration as a proxy for
  competition gives rise to several
• problems
• (1) The inverse relationship between competition
  and concentration is not empirically
• substantiated (Claessens and Laeven, 2004 Beck
  et al., 2006a, 2006b
• Carbo et al., 2006).
• (2) It is an accepted view in the industrial
  organisation literature that measures of market
  structure are not necessarily related to the
  degree of competitiveness (Baumol et al., 1982).
• (3) It propels misleading inferences and gives
  rise to measurement problems as the
• level of concentration is overstated in small
  countries and when the number of
• banks is small (Bikker, 2004).
• (4) It does not measure competitive conduct of
  financial institutions on the marginal level. It
  is not derived from profit-maximizing conditions
  (Shaffer, 2004).

However, no study specifically tests for the
relationship between banks competitive conduct
and its implications for systemic risk in a
cross-country setting.
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(2) Rationale
More research is clearly needed on the topic of
bank concentration and competition. Berger
et al. (2004) Taken from the lead article to
the Special Issue on Bank Concentration and
Competition An Evolution in the Making, Journal
of Money, Credit, and Banking (2004).
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(2) Contributions
Contributions of this study (1) First empirical
analysis of the link between competitive
conduct of banks, measured by the Panzar and
Rosse (1987) H-Statistic, and systemic risk
using cross-country data (38 countries,
19802003). (2) Re-examination of the
relationship between concentration,
competition, and crises. (3) Methodological
advancement on modelling systemic risk using a
parametric duration model with time-varying
covariates. (4) Examination of the impact of
the regulatory environment on the timing of
systemic banking crises.
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(3) Methodological Approach
The Panzar and Rosse (1987) H-Statistic Measures
market power by the extent to which a change in
factor input prices translates into equilibrium
revenues by bank i.
Ri equilibrium value of revenue of bank i wi
vector of m input prices H 0 monopoly
equilibrium 0 lt H lt1 monopolistic competition H
1 perfect competition Data on H-Statistic
obtained from Claessens and Laeven (2004).
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(3) Methodological Approach

• Measuring competition
• The Panzar and Rosse (1987) H-Statistic
• (1) H-Statistic is analytically superior to
  previously used measures of competition (in the
  empirical banking literature), because it
• is derived from profit-maximizing
  conditions (Shaffer, 2004).
• (2) It is robust with respect to the market
  since it only draws upon characteristics of
  reduced-form revenue equations at the firm
• level (Shaffer, 2004).
• (3) Vesala (1995) has shown that the H-Statistic
  is an increasing function of the demand
  elasticity, suggesting as H increases, the less
  market power is exercised by banks.
• Consequently, continuous interpretation is
  appropriate (Claessens and Laeven, 2004, 2005
  Carbo et al., 2006).
• It is widely used in the banking
  literature (e.g. Shaffer, 1982 Molyneux et al.,
  1996 DeBandt and Davis, 2000 Bikker and
• Haaf, 2002 Claessens and Laeven,
  2004 Carbo et al., 2006).

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(3) Methodological Approach
Measuring banking sector stability We use a
dummy variable indicating a systemic banking
crisis Dating scheme obtained from
Demirgüç-Kunt and Detragiache (2005). A systemic
crisis it is based on presence of emergency
measures, large nationalizations, high NPLs, and
high fiscal costs of rescues. It shows 28
systemic crises in 1980 - 2003 for our sample.
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(3) Methodological Approach
We model crises using duration and logit
analysis. I. Duration analysis The dependent
variable measures the time to transition from a
sound banking system to a crisis episode.

• II. Logit analysis
• The model computes the probability for observing
  a crisis.

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Main Results (4) Econometric Analysis
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Main results contd (4) Econometric
Analysis
Competitive behaviour matters for timing and
probability of observing systemic crises, when
the level of concentration, the macroeconomic
environment, deposit insurance design
features and origin of a countrys legal system
are controlled for. Duration analysis indicates
that time to crisis increases in a more
competitive environment whereas the logit model
suggest that competition decreases the
probability of observing a crisis.
Concentration is insignificant in both the
duration and the logit probability models.
This finding will persist throughout the
remainder of the paper.
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Robustness tests (5) Sensitivity
Analyses

• We perform a set of sensitivity analyses using
  both the duration and
• the logit model
• We omit the period 1994 2001 for which
  Claessens and Laeven (2004)
• calculated the H-Statistic.
• (2) We exclude countries for which the
  H-Statistic may be biased.
• (3) We exclude EU countries.
• (4) We exclude low income economies.
• (5) We exclude G10 countries.
• (6) We use first differences for the
  macroeconomic control variables.
• (7) We estimate the model for a shorter sampling
  period between 1985 and 2003.
• (8) We explicitly control for competition from
  stock markets.

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Robustness tests (contd) (5) Sensitivity
Analyses
Summary Both the duration and the logit model
confirm in 22 out of 22 regressions
a significantly positive impact of competition on
banking system soundness.
The duration model assumes a constant hazard
rate. We therefore also test for duration
dependence and additionally investigate the
sensitivity of our results to using a Cox PH
Model. The finding for the positive effect of
competition on banking system soundness is again
confirmed in these additional tests.
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Competitiveness, Regulation and Crises (5)
Sensitivity Analyses

• We test the impact of competitiveness on the
  timing and likelihood of
• systemic crises, whilst controlling for
  regulatory and institutional variables
• We control for entry and activity restrictions.
• We control for a capital regulatory index.
• We control for foreign ownership.
• We control for government ownership.
• We control for the strength of the institutional
  environment (rule of law).
• We test for the effect of a disclosure index.

Both the duration and the logit model confirm in
9 out of 12 regressions a significantly positive
impact of competition on banking system
soundness. ) The H-Statistic is rendered
insignificant in the duration model when entry
restrictions, rule of law, foreign
ownership and the accounting disclosure index
enter the equation. It is only
insignificant in the logit model when rule of law
is controlled for.
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(6) Conclusion

• (1) The first empirical study on the relationship
  between competition, measured by the Panzar and
  Rosse H-Statistic, and the likelihood and timing
  of systemic banking crises.
• (2) Higher degrees of competition in banking
  systems are associated with increased survival
  time of banking systems and go hand in hand with
  a decrease in the probability of systemic banking
  crises.
• Results for the timing and the probability of
  suffering a systemic crisis are robust to a vast
  number of sensitivity tests.
• These findings also hold when concentration is
  accounted for and provide empirical support to
  the assertion that concentration and competition
  describe different characteristics of banking
  systems.
• The results obtained from both methods
  empirically substantiate theoretical research on
  the competition-stability view in the
  literature.
• No claim, that highly competitive banking systems
  are free of failures.

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(6) Future Research

• It is worthwhile to examine whether alternative
  measures of competitive bank conduct support our
  results and which levels of competition, if any,
  are optimal to achieve and sustain banking system
  stability.
• Studies on the firm level, using cross-country
  data and controlling for the regulatory
  environment will help explore the linkages
  further.

We have some ongoing research where we relate
bank capital ratios to the H-Statistic and to
investigate the effect of competition on the way
banks manage their capital.