Does competition help or hinder bank stability in the UK?

Sebastian de-Ramon, Bill Francis and Michael Straughan.

There is a debate in the regulatory and academic community about whether competition is good or bad for bank stability, particularly following the financial crisis (see Chapter 6 of the Independent Commission on Banking final report). The debate tends to be seen as a head-to-head argument between two camps: those that see competition as bad for stability (competition-fragility) versus those that see competition as good (competition-stability). In new research, we look at how competition affects the stability of banks in the UK. We find that competition affects less stable firms differently than more stable firms and that focussing on what happens to the average firm may not be sufficient.

The academic debate

The competition-fragility argument runs that more intense competition reduces margins and profitability, and banks respond by making cost savings (e.g. by reducing screening activities) and increasing risk (e.g. by reducing underwriting standards) (Marcus, 1984; Keeley, 1990). On the competition-stability side, the argument is that more intense competition between banks lowers interest rates for borrowers and hence reduces both borrower default and asset portfolio risk (Boyd and De Nicolò, 2005).

The two-way bet is that both hypotheses stand but one dominates the other depending on current competition intensity – a tug of war between the competing hypotheses (Figure 1). When competition increases in markets already highly competitive, banks have little option but to increase risk to recover profitability and competition-fragility dominates, while in highly concentrated markets the positive effect of more competition on asset quality dominates and the competition-stability hypothesis holds sway (Martinez-Miera and Repullo, 2010).

Figure 1: The tug-of war between the competition-stability and competition-fragility hypotheses

Does the empirical evidence in the literature provide us with an answer? Unfortunately not. We find plenty of studies supporting both hypotheses, and some that find no relationship at all. A meta-study from Czech National Bank researchers (Havránek & Žigraiová, 2015) collects 598 estimates from 31 studies and finds little overall interplay between competition and stability.

However, these studies have a number of common factors. First, they calculate the impact of competition on a bank with an average stability level. Second, they tend to exclude smaller banks and building societies.

But banks differ in how they manage asset and solvency risk and their stability varies significantly over time. So why would competition affect all banks in the same way? Moreover, banks compete in different ways. Small building societies survive alongside banking behemoths, while mid-sized entrants provide new and innovative ways for customers to access finance. Excluding smaller banks or building societies distorts measures of competition.

Our Approach

Our research uses data spanning a 24 year period from 1989 to 2013. The data covers all UK banks and building societies (we’ll call them all banks for simplicity going forward), which means we can look more closely at what happened in the UK over a period in which there has been significant technological, regulatory and business model transformation but largely avoids being distorted by banks reactions to more recent financial market reforms (we discussed these trends and the data in a previous blog).

We investigate the link between bank stability and competition by estimating straightforward linear models that relate the measure of bank stability to competition and bank-level and macroeconomic control variables. The bank-level variables help to account for differences in bank business practices, while the macroeconomic variables account for changes in the economic cycle.

We measure bank stability using the well-established firm-level Z-score measure. The Z-score is a measure of ‘distance to default’ – it calculates how big a negative shock is needed, relative to recent volatility in the bank’s asset returns, to wipe out the bank’s equity and current asset returns. One very useful characteristic of the Z-score is that it can be broken down so that we can see whether changes in bank stability are being driven by asset returns, by a bank’s level of capital, or by both.

To improve confidence in our results, we use several competition measures. The first is the Boone indicator, which measures competition from an efficiency perspective. As competition heats up, more efficient banks should see their assets expand relatively more than less efficient banks, and the Boone indicator measures the extent to which this happens. The second is the Lerner index, which is a measure of banks’ market power. The Lerner index measures banks’ margins, and where there is greater market power (i.e. less competition), margins are fatter. Lastly, the Herfindahl-Hirschman Index (HHI) is a measure of concentration. As concentration increases, there are more opportunities for banks to exert market power and hence competition diminishes, although the link between concentration and competition is less than perfect (see our previous blog for more background).

Competition fragility holds on average …

Our results show that there is support for the competition-fragility hypothesis when we consider the simple (unweighted) average of UK banks. The results are statistically significant and consistent across all competition measures: higher market power improves the stability of banks (results from the Lerner index and HHI), and less efficient bank business models are more sustainable in a lower competition environment (results from the Boone indicator).

That said, this outcome masks different effects on different aspects of banks’ stability. First, greater competition has a negative impact on capital ratios adjusted for asset-return volatility, supportive of the Marcus and Keeley competition-fragility hypothesis. However, greater competition has a positive impact on asset returns adjusted for asset-return volatility, which is consistent with Boyd and De Nicolò’s competition stability hypothesis. So both effects co-exist, but the positive impact on asset returns is outweighed by the negative impact on capital ratios. Having said that, the overall negative impact itself is quite small. If today’s sluggish competitive conditions reverted back to the more competitive late 1990s period – a change in the Boone indicator of around 270% – the Z-score would deteriorate by only around 6 percent. So for a bank that has an average level of stability (regardless of size), our results show that the competition-fragility hypothesis holds. The tug of war between the two competing hypotheses is being won by competition-fragility, but not by much (Figure 2).

Figure 2: The tug-of war between the competition-stability and competition-fragility hypotheses (again)

Our results show that, on average, the positive influence of competition on risk-adjusted asset returns is (just) outweighed by the negative influence of competition on risk-adjusted capital ratios.

… but competition affects different banks differently

However, given that banks operate with very different levels of stability, is it still the case that very weak firms are affected by competition in the same way as very stable firms? We use quantile regression to examine this issue. Quantile regression estimates the relationship between competition and banks in any particular quantile of the Z-score. For example, we can look at the impact on banks with the 5, 10, 25 or 75 percent least stable business models in our dataset (or any other percentage for that matter). So we estimated the impact of competition on bank stability for the 5 percent to 95 percent quantiles of the Z-score in increments of 5 percentage points, using our three competition measures.

Our results now show that there is a favourable effect of competition on bank stability, but only for the least stable firms. The effect of competition on the stability of healthier firms (with higher Z-scores) remains unfavourable. Figure 3 shows these findings for our three measures of competition, setting out the impact of competition (competition-stability in green, competition-fragility in red) for each estimated quantile, and the 95% confidence interval around each estimate. Banks with the lowest 20% of Z‑scores – the least stable quintile – see their stability improve with greater competition according to the Boone indicator and HHI, with no measurable impact according to the Lerner index. For the healthiest 65% of banks (or thereabouts) stability decreases with greater competition, although to a lesser extent than the positive impact on the least stable firms. These findings allow us to put our two sets of results in context: the impact on the ‘average’ bank, shown by the red line, largely reflects the longer tail of relatively healthy banks where competition is negative for risk.

Figure 3: The different effects of competition on different firms

We plot the estimated impact of competition, as measured by the Boone indicator, Lerner index and HHI, respectively, on banks in various quantiles of the Z-score. Values above the x-axes indicate that competition has a favourable impact (marked in green), while values below have an unfavourable impact (marked in red). Where the confidence interval crosses the x-axis, competition has no measurable impact on stability (marked in grey). Our results show that, for the firms in the riskiest quintile (20% of banks with the lowest Z-scores), competition is a either a positive influence (results for the Boone indicator and HHI competition measures) or has no influence (Lerner index) on bank stability. Competition has a negative influence on the risk of healthier banks (65% of banks with the highest Z-scores).

We looked again at the factors driving the outcomes. Figure 4 shows the results for the Boone indicator (results for the other competition measures are essentially the same). We see that the change from a favourable to unfavourable impact is driven entirely by banks’ volatility-adjusted capital ratios. Competition is positive for all banks’ volatility-adjusted asset returns (middle panel, with positive effects shown in green). The effect on capital ratios (right-most panel) is favourable for the least stable 25% of firms, but unfavourable for the healthiest 65% of firms (shown in red).

Figure 4: What drives competition from being favourable to unfavourable for bank stability?

We plot the effect of competition as measured by the Boone indicator on quantiles of the Z-score alongside quantiles of the risk-adjusted return on assets and risk-­adjusted capital ratios, respectively. Values above the x-axes indicate that competition has a favourable impact (marked in green), while values below have an unfavourable impact (marked in red). Where the confidence interval crosses the x-axis, competition has no measurable impact on stability (marked in grey). Our results show that competition has a positive effect on asset returns for all banks, regardless of risk (middle panel). It is the effect on capital ratios (right-hand panel) that drives competition from having a favourable effect on the least stable firms to having an unfavourable effect on healthier firms.

So, while the effects of stronger competition on average bank stability are negative, the effect has a noticeably different and favourable effect on less stable banks. For prudential policy, this outcome lends some support to the application of a leverage ratio across the UK banking sector. As the impact of competition on stability is driven by banks’ capital (i.e. the extent to which banks are leveraged), the mechanism that allows the least stable firms to increase leverage as competition reduces is short-circuited while any decline in stability by healthier firms as competition increases will be limited.

Sebastian de-Ramon, Bill Francis and Michael Straughan work in the Bank’s Policy, Strategy and Implementation Division.

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