Greater competition leads to lower profits, and the banking industry is no exception. In order to increase profits, however, banks tend to make riskier loans, creating a “competition-stability” tradeoff.
A new paper from Dean Corbae and Ross Levine finds that the financial market can increase competition while effectively mitigating the associated increase in financial fragility through regulations that improve corporate governance and limit leverage.
We find that (1) an intensification of competition increases the efficiency and fragility of banks; (2) economies can avoid the fragility costs of competition by enhancing bank governance and tightening leverage requirements; and (3) the monetary transmission mechanism is materially shaped by bank competition in that bank lending responds more aggressively to central bank induced changes in interest rates in more competitive environments. Our research stresses the importance of (a) regulations that improve bank governance because they boost efficiency and stability and (b) explicitly accounting for the structure of the banking system when assessing regulatory and monetary policy.
Other literature casts doubt on the competition-stability tradeoff, finding that more competition increases incentives for more-effective corporate governance and that lower interest rates make it possible for firms to borrow more cheaply, thus reducing their risk of insolvency. Corbae and Levine, however, find that the competition-stability tradeoff exists, due to the short-term interests of managers and the need to make riskier loans to boost profits.
How do the authors recommend addressing this tradeoff? “The right strategy for confronting a situation in which an intensification of competition increases efficiency and fragility is not less competition; the right remedy is to implement regulatory and supervisory reform packages.”
First, by better aligning the incentives of shareholders and managers, good-governance regulations can encourage more long-term thinking by managers to the benefit of shareholders.
Second, greater restrictions on leverage (i.e., higher capital requirements) increase the probability of bank success, particularly when managers’ incentives are more closely aligned with shareholders’.
The intuition is as follows: forcing banks to be equity-financed will reduce the excessive risk-taking more if bank executives are more concerned about the equity value of the bank. The model also indicates that regulations that induce bank executives to focus less on short-run bonuses and more on the longer-run charter value of the bank will have a larger risk-reducing effect when the bank is less levered. The policy implication is potentially first-order: The result stresses that leverage requirements and regulations on executive incentives are reinforcing. It is not just that each independently reduces excessive risk-taking; it is that each policy also magnifies the impact of the other policy. Put differently, tightening leverage requirements in the presence of myopic executives will have much weaker effects on bank stability than tightening leverage requirements when bank executives have less distorted incentives.
Increased competition in the banking sector, in addition to making it cheaper for firms to borrow and invest, also creates an incentive to make riskier (but more profitable) investments in new firms rather than continuing to lend to older, “zombie” firms.
Even so, it’s necessary to balance this risk by ensuring that lending is done by banks that aren’t overleveraged or run by myopic managers.
For more coverage of this paper, read Paul Kiernan and Ryan Tracy’s article in the Wall Street Journal.