Banking’s Biggest Dilemma – Stability or Competition? : Xavier Vives

September 15, 2011Sectorby Xavier Vives

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Banking’s Biggest Dilemma – Stability or Competition? : Xavier Vives

The banking sector faces a continuous trade-off between competition and stability. Too much competition increases instability and the risk of systemic failure, but too little competition will also have dire consequences for consumers and investors. What is the balancing point?

 

 

BARCELONA – Central bankers and regulators tend to worry that too much competition in the financial sector increases instability and the risk of systemic failure. Competition authorities, on the other hand, tend to believe that the more competition, the better. Both can’t be right.

There is a trade-off between competition and stability. Indeed, greater competitive pressure may increase the fragility of banks’ balance sheets and make investors more prone to panics. It may also erode the charter value of institutions.

A bank with thin margins and limited liability does not have much to lose, and will tend to gamble – a tendency that is exacerbated by deposit insurance and too-big-to-fail policies. The result will be more incentives to assume risk. Indeed, for banks close to the failure point in liberalized systems, the evidence of perverse risk-taking incentives is overwhelming.

That is why crises began to increase in number and severity after financial systems in the developed world started to liberalize in the 1970’s, beginning in the United States. This new vulnerability stands in stark contrast to the stability of the over-regulated post-World War II period. The crises in the US in the 1980’s (caused by the savings-and-loan institutions known as “thrifts”), and in Japan and Scandinavia in the 1990’s, showed that financial liberalization without proper regulation induces instability.

In an ideal world, the competition-stability trade-off could be regulated away with sophisticated risk-based insurance mechanisms, credible liquidation and resolution procedures, contingent convertibles, and capital requirements with charges for systemic institutions. The problem is that regulation is unlikely to eliminate completely market failures: the competition-stability trade-off can be ameliorated, but not eliminated.

For example, the United Kingdom’s Independent Commission on Banking (ICB) has proposed ring-fencing retail activities from investment-banking activities in separately capitalized divisions of a bank holding company. This is a compromise aimed at minimizing the incentive to gamble with public insurance while allowing some economies of scale for banking activities.

Related: New UK Bank Rules: US Looks Even More Pathetic

But the devil is in the details, and, even in the most optimistic scenario, the trade-off between competition and stability will remain. One shortcoming of the measure consists in the fact that the crisis has hit both universal and specialized banks. Furthermore, the definition of the boundary between retail and investment-banking activities will leave an important grey area and generate perverse incentives.

And the regulatory boundary problem persists: risky activities may migrate to areas where regulation is lax and reproduce the problems with the shadow banking system that we have witnessed during the crisis. As a result, investment-banking operations might need to be rescued if they pose a systemic threat.