Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective

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.bank competition;efficiency;soundness;Boone indicator;quantile regression

The Inter-temporal relationship between Risk, Capital and Efficiency: The case of Islamic and conventional banks

The paper investigates the relationship between risk, capital and efficiency for Islamic and conventional banks using a dataset spanning 14 countries over the 2000-2012 period. We use the z-score as a proxy for insolvency risk, cost efficiency is estimated via a stochastic frontier approach and capitalisation is reflected on the equity to assets ratio. An array of bank-specific, macroeconomic and market structure variables are used in a system of three equations, estimated using the seemingly unrelated regression (SUR) technique. We find that the capitalisation response to increases in insolvency risk is more pronounced for Islamic banks but has an approximately five-times smaller effect on risk mitigation compared to conventional banks. Higher cost efficiency is related to lower risk for conventional banks, but the opposite is true for Islamic banks. The link between cost efficiency and capitalisation attests to a substitutional effect for the case of conventional banks, but a complementary effect for Islamic banks. Our findings give new insights on the use of efficiency to gauge capital requirements for financial institutions and are particularly relevant for regulators and policy makers in countries where both bank types operate

Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective

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