Competition and stability in banking

Xavier Vives 18 September 2010

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In a CEPR Report on financial regulation published last year in a world still shaking from the global crisis (Beck et al. 2009), the authors introduce the issue of competition and stability in the banking sector as being “inevitably intertwined. Since the Great Depression policymakers have struggled to define the right mix of competition rules and regulations specific to the banking sector.” They are still struggling. In a recent Policy Insight (Vives 2010), I offer my own views to the debate.

There was a time when banking was one of the most regulated sectors in the economy. That was just after the last crisis in the 1930s. The recent history of the financial sector can be divided into two periods. The first, from the 1940s up to the 1970s, was characterised by tight regulation, intervention, and stability, while the second was marked by liberalisation and greater instability.

In the first period, competition was considered detrimental to stability and in many countries competition policy was not applied fully to this sector until recently – despite its importance within the economy and the costs and inefficiencies induced by financial repression. Central banks and regulators were often complacent about collusion among banks, preferring to deal with a concentrated sector characterised by soft rivalry.

This changed in the second period with deregulation and the idea that competition enhances efficiency. Competition policy, at least, is now taken seriously in the banking sector. This later period of liberalisation reached crisis point in 2007. Starting with a disturbance in the subprime mortgage market, the instability spilled over to a full-blown global crisis following the demise of Lehman Brothers in September 2008. As of November 2009, the cumulative banking losses are estimated at €1.1 trillion.

The global crisis has overridden competition policy concerns. In the EU and the US, up to 30% of GDP has been committed to the banking sector through massive bailouts and state aid. Public help programmes have distorted competition and created an uneven playing field, in terms of the cost of capital and perception of safety and soundness of different entities. Market power concerns about mergers have also been overruled. In the UK, Lloyds TBS took over the troubled HBOS (merger of Halifax and Bank of Scotland) in a merger opposed by the Office of Fair Trade, while in 2001 the same Lloyds TBS had not been allowed to take over Abbey. The investment banking business has been consolidated in the US, with the forced takeovers of Bear Sterns by JP Morgan, and Merrill Lynch by Bank of America. The result is potentially weak competition among the remaining players. Those events have deepened a current trend toward increased consolidation within countries, across countries and across business lines.

Banking as a unique sector

Banking and financial markets display the whole array of classical market failures, due to externalities (fragility due to coordination problems and contagion), asymmetric information (excessive risk taking with agency problems, moral hazard and adverse selection), and potential market power. This has brought in regulation to protect the system, small investors, and market competitiveness. But these problems are exacerbated by policies dealing with the lender of last resort, deposit insurance and being “too big to fail”. The global crisis has ruthlessly uncovered the massive regulatory failure and potential contradictions between regulatory intervention and competition policy.

Indeed, banks are unique, because of their particular mix of features, which makes them vulnerable to runs with potentially systemic impact, and very important negative externalities for the economy (see Beck et al. 2009). The fragility of a competitive banking system is typically excessive. Financial regulation comes to the rescue at the cost of side effects and regulatory failure. The most important one is the potential moral hazard induced by protection and bailouts extended to failing institutions. The present crisis is a testimony to the failure of the three pillars of the Basel II system.

  • Disclosure and risk assessment have been deficient (think of the failure of rating agencies), and market discipline has been ineffective because of the blanket insurance offered by too-big-to-fail policies.
  • Capital regulation has not taken into account systemic effects (the social cost of failure) and assets restrictions have been lifted, under pressure from investment bank lobbies.
  • Supervision has proved ineffective, since it has allowed a shadow banking system to grow unchecked.

A trade-off between competition and stability

Theory and empirics point to the existence of a trade-off between competition and stability along some dimensions. Runs happen independently of the level of competition, but more competitive pressure worsens the coordination problem of investors/depositors and increases potential instability, the probability of a crisis, and the impact of bad news on fundamentals. This does not imply that competitive pressure has to be minimised, since in general the socially optimal probability of a crisis is positive, because of its disciplining effect. On the asset side, once a certain threshold is reached, an increase in the level of competition will tend to boost risk-taking incentives and the probability of bank failure. This tendency may be checked by appropriate regulation and supervision. The evidence points to liberalisation increasing banking crises, while a strong institutional environment and adequate regulation reduces them. At the same time, there is a positive association between some measures of bank competition (for example, low entry barriers, openness to foreign entry) and stability.

Regulation can alleviate the competition-stability trade-off, but the design of optimal regulation has to take into account the intensity of competition. For example, capital charges should reflect the degree of friction and rivalry in the banking environment, with tighter requirements in more competitive situations. Given that fine-tuning of regulation has proved very difficult in practice (this is probably an understatement given the massive regulatory failure that the crisis has uncovered), the trade-off between competition and stability is bound to persist, suggesting that coordinating regulation and competition policy is necessary. Banks’ uniqueness, not only during crises, should be recognised and the appropriate lessons drawn and applied when implementing competition policy.

Merger policy in banking should be consistent over time and keep in mind an optimal degree of concentration and dynamic incentives (rewarding prudence and easing entry). How to deal with too-big-to-fail institutions remains an open issue. In the US, too-big-to-fail is not an antitrust issue, whereas in the EU the competition authority controls distortions of competition which arise out of state aid, and this has implications for too-big-to-fail. The credibility of the competition authority to impose conditions once an institution has been helped may provide a commitment device which has been lacking in bank bailouts. Controls on size are problematic, because interconnectedness and line of business specialisation are more relevant to systemic risk than size. In terms of the scope of any bank’s activities, conflict of interest is what leads to potential market failure and should be the focus for any limitations.

Collaboration between regulation and competition policy

All this calls for close collaboration between the regulator (in charge of stability and prudential control) and the competition authority (in charge of keeping the market competitive).

  • First, regulatory requirements and competition policy need to be coordinated. Capital charges may have to be fine-tuned to match the intensity of competition in different market segments.
  • Second, a protocol for cooperation between the regulator and the competition authority should be developed. This is particularly important in crises. The competition authority can commit to addressing too-big-to-fail problems that lead to competition distortions; the regulator can address the too-big-to-fail issue and moral hazard through systemic capital charges, effective resolution procedures, and restrictions on the scope of banking activities that target conflicts of interest.
  • Finally, crisis procedures should be established that define liquidity help from recapitalisation and conditions for restructuring to avoid competitive distortions. Entities close to insolvency should be tightly regulated (and activities restricted) in a framework permitting prompt corrective action.

References

Vives, Xavier (2010), “Competition and stability in banking”, CEPR Policy Insight 50.

Beck, Thorsten, Diane Coyle, Mathias Dewatripont, Xavier Freixas and Paul Seabright (2009), “Bailing out the banks: Reconciling stability and competition”, A CEPR Report.

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Topics:  Competition policy Financial markets

Tags:  financial regulation, banking regulation

Professor of Economics and Finance and Academic Director of the Public-Private Sector Research Center at IESE Business School; CEPR Research Fellow

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