Competition and Stability in Banking: The Role of Regulation and Competition Policy

Xavier Vives is professor of Economics and Finance, Abertis Chair of Regulation, Competition and Public Policy, and academic director of the Public-Private Research Center at IESE Business School. This post is based on his recent book, available here.

Competition has been perceived with suspicion, and even suppressed for extended periods, in banking. After banking was liberalized, a process which started in the 1970s in the United States, it has become much more unstable, culminating with the 2007–2009 crisis which resembles the systemic banking problems of the 1930s.

Is competition in banking good for society? What policies can best protect and stabilize banking and the financial system without stifling it? Has excessive competition helped the overexpansion of credit in the real state sector? Competition has a bearing on all the major perceived failures associated with banking: excessive risk taking by financial intermediaries, credit overexpansion, and bank misconduct (e.g., the Libor manipulation). However, we have to ascertain whether competition is responsible for instability, or instead we have to blame inadequate regulation and supervision.

The evolution of a financial liberalization episode involves typically increased competitive pressure on financial institutions (for example, competition from nonbank intermediaries allowed by deregulation) which leads banks to over-expand in new and/or risky lines of business (real estate is a good example). The consequence is increased risk taking which is not checked because of lax supervision and/or inadequate prudential requirements. This was the case of the Savings and Loan (S&L) crisis in the United States in the 1980s. Liberalization calls for a strengthening of solvency requirements, but this prudential rule has not been followed in many liberalization and deregulation episodes, with harmful consequences as we witnessed painfully in the 2007–2009 crisis.

My book, Competition and Stability in Banking: The Role of Regulation and Competition Policy, analyzes the relationship between competition and stability in banking and derives the policy implications for regulation and competition policy. Competition policy was not applied to the banking sector for a long period because it was thought detrimental to stability. This changed with the liberalization process but again was put into question with the massive help to the financial system in the aftermath of the 2007–2009 crisis, which induced multiple competitive distortions. Witness the banking mergers during the crisis that may have consolidated an anticompetitive market structure. The tension between competition and stability also surfaces as a lack of coordination between prudential and competition policies as we have seen in the run to crisis episodes.

The approach taken in the book draws both from the Industrial Organization and Financial Intermediation literatures. Its uniqueness is that it provides an up-to-date review of the theory and empirics of banking competition and its relationship with stability, and incorporates the analysis of modern market-based banking, systemic risk, and macro-prudential regulation. It incorporates the study of issues such as the appearance of new competitors to banks from the digital world, and the influence of the behavioral biases of consumers and investors in banking and finance. It offers also an extended survey of competition policy practice in the banking sector both in developed and emerging economies, and examines numerous competition policy cases. It also explains how crisis interventions, in particular after 2008, have interacted with competition policy and the role that the latter should have in a crisis.

The book argues that there is a significant trade-off between competition and financial stability, and that it cannot be fully regulated away. If there were no trade-off between competition and financial stability, then competition policy need not be fine-tuned for the banking sector, and banking would be like any other sector. Even if there was a trade-off, if it could be regulated away then again the implementation of competition policy would be clean: just maximize competitive pressure independently of the (optimal) regulation. However, if we cannot eliminate by regulation the sources of market failure other than market power that afflict banking (namely, externalities, asymmetric information and behavioral biases), then we cannot be sure that by maximizing competitive pressure we improve welfare.

When the trade-off cannot be regulated away completely, we have to consider the interaction between regulation and competition policy. More specifically, we have to see whether regulation and competition policy must be viewed as complementary or substitutable policy tools, and how they should be coordinated.

Regulation can, indeed, improve the trade-off between competition and stability but, given the prevalence of regulatory failure, it cannot be expected to eliminate it. Let us give four examples of the need to coordinate regulation and competition policy. First, in a more competitive environment the solvency requirement should be strengthened with the capital requirement level increasing in both the social cost of failure and the intensity of competition for funds. Second, when the prudential authority imposes deposit rate limits to entities that exploit deposit insurance to attract funds and increase systemic risk, it restricts competition directly. Third, when in expansions banks have incentives to over-lend and consumers to over-borrow (the latter perhaps because of behavioral biases), prudential rules limiting the amount of a mortgage loan that can be given as a percentage of the value of the house or consumer protection rules restricting the choice that intermediaries can offer consumers, restrict competition among banks at the same time that they avoid the buildup of risk in the real estate sector. In the last two cases, the prudential authority, by imposing restrictions on the actions of banks, makes competition more effective in delivering consumer and investor welfare, and attenuates systemic risk. Finally, the urge in a crisis to resolve distressed entities by merging them with sound ones, may consolidate anticompetitive and TBTF market structures. Here the competition authority has to keep a long-term perspective.

Competition policy can be also complementary to prudential policies. For example, competition policy may be a good tool to attack the TBTF issue by controlling the competitive distortions that TBTF entities generate. This has been proven useful in the EU where the competition authority in Brussels has jurisdiction over state aid.

The fact that competition policy and prudential regulation need to be coordinated does not mean that both functions need to be under same regulatory roof. Indeed, there is a strong case to have separate authorities dealing with competition policy and supervision in banking. Furthermore, there is a case also for consumer protection to be under the same roof as competition policy, since both have as objective consumer welfare. This integration has been implemented in the new UK financial architecture (under the Financial Conduct Authority) but not in continental Europe, where consumer protection tends to remain under the wing of the prudential authority.

The fact that there is a trade-off between competition and stability does not mean that we have to give up trying to improve it. In fact, there is ample room to design regulations that at the same time increase the stability of the system and effective competition in financial intermediation. This is a main challenge for banking regulation.

The book is available for purchase here.

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