Bank Competition and Financial Stability Research Paper

Bank Competition and Financial Stability - Research Paper Example Cross-border mergers and entry of foreign banks into the developing countries have been consistent. Consolidation leads to efficiency and scale economy arguments, but accompanying it rises debates regarding the stability (Cooper, 2008). Economic Theory comes up with ambiguous results about the structure of the market and the competitiveness and stability of the banking sector. Empirical findings also provide similar ambiguous results (Beck, 2008, pp 1). There are basically two thoughts relevant in identifying the relation between financial stability and bank competition. One, the completion fragility view infers that any competition within the market will result in lowering of the profits for the firms since competition decreases market power. Two, the competition-stability view infers that as the banks become more powerful in the loan market, they keep taking higher risks (Allen & Gale, 2004). This paper will therefore offer a critical insight into understanding the key variables of the relationship between financial stability and bank competition. Stability and Competition Detragiache defines banking distress as when nonperforming assets reach a significantly large percent of total assets, emergency measures are taken to assist the banking system and large-scale bank nationalizations take place. Honohan and Laeven tell how the financial crisis have spread all over the globe where both big and small countries have been hit. Failures of large international banks, which have branches in the small countries, have affected the developing economies as well. Bank stability has been measured in terms of levels or closeness to bankruptcy. Researchers usually use the Z-score which is measured by the sum of capital asset ratio and the return on assets weighted by the standard deviation of return of assets (Beck, 2008, pp 4). Another measure has been the non-performing loan ratio as an indicator of fragility. Both exclude actual bank failures. Bank competition measures i nclude market structure measures such as Herfindahl indices and concentration ratios which are crude measures. Next, there is H-statistic which measures the reaction of input to output prices. Lastly, Regulatory framework indicators such as entry requirements, barriers and other restrictions allow indications competition (Beck, 2008, Pp 6, 7). Theoretical predictions Theoretical models have reported contrasting predictions on the bank stability and concentration. Most theoretical models avoid making distinctions between concentration and competition and resort to one to one mapping from market structure to competitive behavior of the banks. Under this we have two hypotheses. Competition-Fragility Hypothesis: Certain models infer that less competitive banking structures are more stable and fragility is prevented by the buffer generated by the profits. It also creates opportunities for additional risk undertaking (Beck, 2008, pp 7-8). In a competitive scenario with profits getting squ eezed, banks take to more risk undertaking resulting in greater fragility. On the other hand, under limited competition banks have greater profit opportunities and do not resort to additional risks (Allen and Gale 2000, 2004). Another scenario where competition can impact stability in the interbank market and payment system. Perfect competition prevents banks from providing liquidity to banks hit by temporary shortages.