Is There a Conflict between Competition and Financial Stability?

Barbara Casu, Claudia Girardone and Philip Molyneux 3.1 INTRODUCTION Crises in the global financial system have impacted severely on many banking sectors with institutions experiencing major losses and necessitating raising additional capital privately or through their respective national governments (via various rescue and bailout schemes).1 The failure of depositors, investors and regulators to discipline banks adequately has led various commentators to reconsider the links between bank stability and changes in the competitive environment.2 While there is an established literature on the measurement of competition and its implications for bank performance, the literature on competition and financial stability is less developed.3 Two views are outlined in the literature. The first, known as the competitionfragility (charter or franchise value) view, argues that banks earn monopoly rents in uncompetitive markets resulting in higher profits, capital ratios and charter values. This makes them better placed to withstand demand- or supply-side shocks and discourages excessive risk-taking (Allen and Gale, 2000, 2004; Carletti, 2008). The second, referred to as the competition-stability view, argues that competition leads to less fragility. The argument goes that in concentrated banking systems with low levels of competition, the market power of incumbent banks results in higher interest rates for borrowers, making it more difficult for them to repay loans. These higher interest rates increase the incentives for borrowers to take on greater risk in search of higher returns. This, in turn, increases the possibility of the non-repayment of loans and the default risk of bank portfolios, making the financial system….