Are Competitive Banking systems more stable?

1. Are Competitive Banking systems more stable? Discussion By Erlend Nier

2. Summary • Two views: • Competition – fragility (C-F) view • Competition – stability (C-S) view • Question: is competition associated with increase or decrease in likelihood of systemic crises?

3. Summary • Analyse this using cross-country regressions • In sample of 38 countries over 1980-2003 • Measuring competition by Panzar- Rosse H-statistic, Claessens and Laeven (2004) • Using account of systemic crises provided by Demirguc-Kunt and Detragiache (2005). • Find evidence in favour of competition –stability (C-S) view.

4. Comments • This is an interesting, if somewhat surprising result. • Most of the theory, eg Keeley (1990) argues that an increase in competition (as preceded by financial liberalisation) would tend to increase fragility. • There is evidence that a number of financial crises (eg US 1980s, Nordic countries 1990s) were preceded by financial liberalisations and associated increases in competition. • Authors may need to do more to fully convince the reader.

5. Comments • Simultaneity: most theory views both competition and stability as outcomes. • S=f (government safety nets, strength of institutions, financial market development, etc) • C=f (entry regulation, size of market, technology, financial market development, etc) • Setup here does not fully recognise this. • Relationship might not be causal, • There may be an endogeneity bias. • Difficult to identify policy measures, that could have a reliable effect.

6. Comments • Is there an independent mechanism that links competition and stability (C-S)? • Eg, does competition foster efficiency and hence stability? • This could be be more fully described, or even analysed econometrcically. • Efficiency measures are available across countries, eg from Demirguc-Kunt, Laeven and Levine (2003) • Crisis regressions control for a number of variables, • some of which might have an independent effect on stability, • but some through competition, eg activity restrictions.

7. Comments • More convincing: identify the C-S mechanism using instrumental variable techniques • instrument H-statistic by employing variables that have a direct effect on competition, but not on stability. • eg entry restrictions, as available from Barth et al (2004), activity restrictions, etc • In the second step, control more fully for variables that have a impact on stability, including strength of institutions, eg as measured by rule of law, Demirguc-Kunt and Detragiache (2002)

8. Comments • Is it competition from banks or competition from financial markets, or both? • Crisis regressions control for legal origin, since this is seen as important determinant of financial market development (amongst other things). • But more direct measures of financial market development are available (eg stock market cap, credit to GDP, etc, from Beck et al 1999) and could be used in the first or second step.

9. Comments • Robustness: results hold for crisis definition presented by Demirguc-Kunt and Detragiache (2005) • but not for Caprio and Klingebiel (2003). • Some differences are: Italy 1990-95 and US 1980-92. • Claessens and Laeven point out that their H-statistic might be biased downward for countries with many banks, such as Italy, US. • Could exclude these countries as a robustness check when using D-K and D (2005).

10. Comments • H-statistic assumes long-run equilibrium. But crises, consolidations and changes in regulation make this a strong assumption. • Could also have a difficulty if competitive conduct in crisis times is different from conduct in stable times. • Could run a test excluding the sample period over which H was measured 1994-2001.

11. Comments • For further research: reconciling the evidence. • Could the short-run effect of financial liberalisations and competition be different from its long-run effects? • This paper suggests that in the long-run, efficiency benefits create stability. • But in the short –run competition can destabilise. • Need for time series – cross-section data on competition to analyse this more fully.