#08-13
Banking Structures and Financial Stability
Allen N. Berger, Leora F. Klapper and Rima Turk-Ariss
Abstract:Under the traditional “competition-fragility” view, more bank competition erodes market power, decreases profit margins, and results in reduced franchise value that encourages bank risk taking. Under the alternative “competition-stability” view, more market power in the loan market may result in higher bank risk as the higher interest rates charged to loan customers make it harder to repay loans, and exacerbate moral hazard and adverse selection problems. The two strands of the literature need not necessarily yield opposing predictions regarding the effects of competition and market power on stability in banking. Even if market power in the loan market results in riskier loan portfolios, the overall risks of banks need not increase if banks protect their franchise values by increasing their equity capital or engaging in other risk-mitigating techniques. We test these theories by regressing measures of loan risk, bank risk, and bank equity capital on several measures of market power, as well as indicators of the business environment, using data for 8,274 banks in 29 developed nations and 827 banks in 60 developing nations. Our results suggest that for developed nations, banks with a higher degree of market power also have less overall risk exposure, consistent with the traditional “competition-fragility” view. The data for developed nations also provides some support for one element of the “competition-stability” view – that market power increases loan portfolio risk. However, this risk is offset in part by higher equity capital ratios. For developing nations, the results are more mixed and dependent on the measure of market power. This may be due in part to the much smaller number of observations on banks in developing nations.
Keywords: Bank Competition, Banking System Fragility, Financial Stability, Regulation
JEL classifications: G21, F30, L89, G38
