How Does Bank Competition Affect Systemic Stability?
45 Pages Posted: 13 Mar 2012 Last revised: 8 Dec 2013
Date Written: November 2013
Using bank level measures of competition and co-dependence, we show a robust negative relationship between bank competition and systemic risk. Whereas much of the extant literature has focused on the relationship between competition and the absolute level of risk of individual banks, in this paper we examine the correlation in the risk taking behavior of banks. We find that greater competition encourages banks to take on more diversified risks, making the banking system less fragile to shocks. Examining the impact of the institutional and regulatory environment on bank systemic risk shows that banking systems are more fragile in countries with weak supervision and private monitoring, greater government ownership of banks, and with public policies that restrict competition. We also find that the negative effect of lack of competition can be mitigated by a strong institutional environment that allows for efficient public and private monitoring of financial institutions.
Keywords: Systemic risk, bank competition, credit risk, merton model, distance to default, default risk, lerner index, bank concentration
JEL Classification: G21, L11, L14
Suggested Citation: Suggested Citation