Bank Concentration, Competition, and Crises: First results

Introduction The consolidation of banks around the globe is fueling an active public policy debate on the impact of consolidation on financial stability.1 Indeed, economic theory provides conflicting predictions about the relationship between the concentration and the competitiveness of the banking industry and banking system fragility. Motivated by public policy debates and ambiguous theoretical predictions, this paper investigates empirically the impact of bank concentration and bank regulations on banking system stability. Some theoretical arguments and country comparisons suggest that a less concentrated banking sector with many banks is more prone to financial crises than a concentrated banking sector with a few banks (Allen and Gale, 2000, 2004). First, concentrated banking systems may enhance market power and boost bank profits. High profits provide a "buffer" against adverse shocks and increase the charter or franchise value of the bank, reducing incentives for bank owners and managers to take excessive risk and thus reducing the probability of systemic banking distress (Hellmann, Murdoch, and Stiglitz, 2000; Besanko and Thakor, 1993; Boot and Greenbaum, 1993, Matutes and Vives, 2000). 2 Second, some hold that it is substantially easier to monitor a few banks in a concentrated banking system than it is to monitor lots of banks in a diffuse banking system. From this perspective, supervision of banks will be more effective and the risks of contagion and thus systemic crisis less pronounced in a concentrated banking system. According to Allen and Gale (2000), the U.S., with its large number of banks, supports this ''concentration-stability" view since it has had a history of much greater financial instability than the U.K or Canada, where the banking sector is dominated by fewer larger banks.3 An opposing view is that a more concentrated banking structure enhances bank fragility. First, Boyd and De Nicolo (2005) argue that the standard argument that market power in banking boosts profits and hence bank stability ignores the potential impact of banks' market power on firm behavior. They confirm that concentrated banking systems enhance market power, which allows banks to boost the interest rate they charge to firms. Boyd and De Nicolo's (2005) theoretical model, however, shows that these higher interest rates may induce firms to assume greater risk. Thus, in many parameterizations of the model, Boyd, and De Nicolo (2005) find a positive relationship between concentration and bank fragility and thus the probability of systemic distress. Similarly, Caminal and Matutes (2002) show that less competition can lead to less credit rationing, larger loans and higher probability of failure if loans are subject to multiplicative uncertainty. Second, advocates of the "concentration-fragility" view argue that (i) relative to diffuse banking systems, concentrated banking systems generally have fewer banks and (ii) policymakers are more concerned about bank failures when there are only a few banks download