Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective
International Monetary Fund (IMF)
July 6, 2010
European Banking Center Discussion Paper No. 2010-20S
CentER Discussion Paper Series No. 2010-68S
How can competition enhance bank soundness? Does competition improve soundness via the efficiency channel? Do banks heterogeneously respond to competition? To answer these questions, we exploit an innovative measure of competition [Boone, J., A New Way to Measure Competition, EconJnl, Vol. 118, pp. 1245-1261] that captures the reallocation of profits from inefficient banks to their efficient counterparts. Based on two complementary datasets for Europe and the U.S., we first establish that the new competition indicator captures a broad variety of other characteristics of competition in a consistent manner. Second, we verify that competition increases efficiency. Third, we present novel evidence that efficiency is the conduit through which competition contributes to bank soundness. In a final examination of banks’ heterogeneous responses to competition, we find that smaller banks’ soundness measures respond more strongly to competition than larger banks’ soundness measures, and two-stage quantile regressions indicate that the soundness-enhancing effect of competition is larger in magnitude for sound banks than for fragile banks.
Number of Pages in PDF File: 44
Keywords: bank competition, efficiency, soundness; Boone indicator; quantile regression
JEL Classification: G21; G28
Date posted: July 7, 2010
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