How Does Competition Affect Efficiency and Soundness in Banking? New Empirical Evidence

Abstract

A growing body of literature indicates that competition increases bank soundness. Applying an industrial organization based approach to large data sets for European and U.S. banks, we offer new empirical evidence that efficiency plays a key role in the transmission from competition to soundness. We use a two-pronged approach. First, we employ Granger causality tests to establish the link between competition and measures of profit efficiency in banking, and find that competition indeed increases bank efficiency. Second, building on these results, we examine the relation between the Boone indicator [Boone, J. (2001) Intensity of competition and the incentive to innovate. IJIO, Vol. 19, pp. 705-726], an innovative measure of competition that focuses on the impact of competition on performance of efficient banks, and relate this measure to bank soundness. We find evidence that competition robustly increases bank soundness, via the efficiency channel.

Keywords: bank competition, efficiency, soundness, market structure, regulation

JEL Classification: G21, G28, L11