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Banking Sector Competition

Key Terms Explained

Banking Sector Competition


Competition is desirable for maximization of social welfare and existence of Pareto efficiency.1 As in other industries, competition in banking system is also needed for efficiency and maximization of social welfare. However, due to its roles and functions, there are some properties that distinguish it from other industries. Hence, it is important to not only make sure that banking sector is competitive and efficient, but also stable.

There are two hypotheses about the relationship between competition and financial stability in the banking system, namely competition-fragility and competition-stability: competition-fragility argues that competition reduces profits, erodes charter value of banks, and raises incentives for excessive risk taking behavior, thereby leading to fragility. On the other hand, competition-stability suggests that higher interest rates in less competitive environments may cause borrowers to take higher risks, resulting in higher probability of non-performing loans and a more fragile system. These views are supported theoretically by a great many of studies.2

Not all the theoretical studies propose a clear positive or negative link between competition and stability. Hence, besides the competition-fragility and competition-stability views, there is a view stating that the relation between market structure and stability of banking sector is not straightforward. They argue that this relation is complex and has important interactions with macroeconomic, regulatory and institutional framework of countries and changes with different model specifications.3

New studies show that competition by itself does not lead to instability, but the links are exacerbated in countries with lower levels of foreign ownership, weak investor protection, generous safety nets, and weak regulation and supervision.4 Therefore, with the right regulatory framework, competition in the banking sector is positive — it promotes efficiency and financial inclusion, without necessarily undermining financial stability.5 Evidence has shown that countries with strong regulatory and institutional frameworks have been less prone to financial distress. Better prudential regulation and supervision can improve stability going forward. Restrictions to competition would not contribute to a greater resilience of financial institutions to financial distress. Instead, they would just have a negative effect on efficiency.6 Hence, we need to focus on establishing policies that help align private incentives with public interest, and take steps to limit the potentially negative consequences on bank competition and risk-taking.7

Measurement of Banking Competition

It is difficulty to measure competition in the financial industry, as characteristics such as information asymmetries in corporate borrowing, switching costs in retail banking and network externalities in payment systems take the financial industry outside the traditional structure-conduct-performance paradigm.  For a while, banking concentration is the most widely used proxy to assess banking competition. However, many studies have found that concentration measures alone are not good predictors of competition.8 Studies find that the measurement should also account for the market contestability of the banking sector such as barriers to entry and exit as well as the strategic reaction of banks such as pricing behavior or market power.

To measure markets contestability, there is an overall index of barriers to entry and total share of applications for bank licenses that were denied. For indicators of banks’ pricing behavior, the H-Statistic (measures elasticity of bank’s revenues to input prices), Lerner index (calculates the mark-up of output prices over marginal cost), and Boone indicator ( assesses the sensitivity of firm’s profits to efficiency) are interpreted as a measure of the degree of competition in the banking market. 9

These measurements have pointed out that the banking systems are more competitive in industrial than developing countries. Banking competition has also improved for developing countries over the last 3 years, and declined for industrialized countries.10

1 Whish, R. (2005), “Competition Law”, Oxford University Press Inc., New York.
2 Beck, T.(2008,June). Bank Competition and Financial Stability: Friends or Foes?
3 OECD. (2010). Competition, Concentration and Stability in the Banking Sector. OECD
4 Anginer and others, 2012
6 OECD. (2010). Competition, Concentration and Stability in the Banking Sector. OECD
8 Cetorelli (1999), Claessens and Laeven (2004), and Demirgüç-Kunt, Laeven, and Levine (2004)
9 Panzar and Rosse, 1982, 1987

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