Master Thesis. The impact of regulation and the relationship between competition and bank stability. R.H.T. Verschuren s134477

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1 Master Thesis The impact of regulation and the relationship between competition and bank stability Author: R.H.T. Verschuren s Supervisor: dr. J.M. Liberti Second reader: dr. M.F. Penas University: Tilburg School of Economics and Management, Tilburg University Study program: Master Finance Faculty: Faculty of Economics and Business Administration Department: Finance Defense date: 28 th of January, 2014

2 Abstract In contrast with research on the relationship of competition and bank stability, research on the impact of regulations on this relationship is a topic which is explored less. Therefore, the main objective of this study is determining the influence of regulations on the competition-stability relationship in the banking-sector. In addition, other determinants of bank stability and the relationship between competition and stability will be tested as well. This will be done by an empirical research by combining datasets on bank competition, stability and regulations covering 12 countries from 1999 to This thesis finds evidence indicating a positive effect of competition on bank stability. Furthermore, results indicate that regulations have a positive direct influence on bank stability. Similarly, this study also finds that high regulations increase the impact of competition on stability. These findings suggest that policymakers should stimulate competition and regulations in the banking-sector. 2

3 Table of contents 1. Introduction Literature review Competition and stability Two views on the competition-stability relationship Competition and concentration Measuring competition and the Panzar-Rosse model Measuring stability Regulation Effects of regulation on competition and stability Measuring regulation Hypothesis development Methodology Data Competition Stability Regulation Sample selection Research steps Empirical study Summary statistics Competition and regulation influencing stability Country analysis Regulation components Regulations influencing competition Conclusion...39 References...41 Appendix

4 1. Introduction The recent financial crisis has revived the corporate governance discussion in the financial world. The banking sector is blamed a lot for causing this crisis. During the financial crisis many banks were nationalized and Basel III was implemented. Basel III, which is a global regulatory standard for banks, was needed because the banking crisis of had proven that capital requirements imposed by Basel II were insufficient. The objective for this new Basel accord is increasing liquidity and decreasing leverage, which should result in a more stable bank. Caused by this recent crisis, the restrictions in the banking sector have become more stringent, which should has to lead to more stable banks. Commonly used bank regulations next to capital requirements are deposit insurance schemes and activity restrictions. But the question is whether these policies have the desired effect or not? According to Bhattacharya, Boot, and Thakor (1998), who discuss existing literature on this topic, the basic message of contemporary banking theory is that banks may be inherently fragile in their role as providers of liquidity, and that this creates a role for a public safety net, either through governmental deposit insurance or through other mechanisms like a Central Bank functioning as a lender of last resort. However, the public safety net has numerous costs, including deadweight taxation costs, distorted asset portfolio choices of banks, and artificial restrictions on banking activities that may be efficiency-depleting. Given the explosive growth in market-provided liquidity as well as off-balancesheet banking, a serious look at the desirability of governmental deposit insurance is called for (p.766). Critics suggest that the banks should go back to their initial role as servant for entrepreneurs and consumers instead of doing universal banking, which contains being a commercial and investment bank at the same time. They say that universal banking entails moral hazard problems, which causes instability. Boyd, Chang, and Smith (1998) support the claims of the opponents of this universal banking system and conclude that universal banks do not operate more efficient than commercial banks. Broadening the banking activities would increase to opportunity to increase risk, which worsens the moral hazard problem. There is also contradicting evidence, claiming that restricting bank activities enhances moral hazard (Barth, Caprio, & Levine, 2001; Beck, Demirgüç-Kunt, & Levine, 2006). Nevertheless, until now banks are still treated as a special kind of firms because they are a pivot in the financial system, on which many governments, firms and institutions depend. This dependence causes that big banks are often described as too-big-to-fail, meaning that the bankruptcy of an important bank would have so many implications for the financial market that governments will intervene. This could result in a moral hazard problem between bank management and government, since managers have a lack of incentives to reduce risk and maintain a stable banking sector, which is important for society and its confidence in the economy as well as the probability of bank failures. 4

5 In addition, another determinant in influencing banking stability is competition. Theory of the relationship between competition and stability in the financial sector shows ambiguous results (Beck, 2008). Which is also stressed by Claessens and Laeven (2004), who say that the view that competition is unambiguously good in banking is more naïve than in other industries, and vigorous rivalry may not be the first best for financial sector performance (p.566). The traditional competition-fragility view expects that more competition in banking enhances a decrease in stability and thus more fragility in banking (Berger, Klapper, & Turk-Ariss, 2009; Carletti & Hartmann, 2002). This fragility is caused by the fact that if banks lose market power due to high competition, they will take on more risk in order to increase return. On the other side, more recent work by Boyd and De Nicolò (2005) and Boyd, De Nicolò, and Jalal (2006) show evidence for the competition-stability view. This view explains that more competition in banking will decrease risk-taking and will increase stability. Nevertheless, the first view is widely accepted and implicates the existence of a trade-off between competition and stability. As a result of the growing importance of regulations in the financial world and the existing debate on the competition-stability relationship, it seems to be relevant to find out which effects these regulations have on competition and stability. Additionally, Carletti (2008) who studied the effects of regulatory policies on the competition-stability trade-off, states that it is surprising that such an important and relevant topic is not explored as elaborately as might be expected. Moreover, Barth, Caprio, and Levine (2013) say that their database on regulations is suitable for combining with other data in order to test the effects of these regulations. Therefore, this research will examine what the impact of the regulations in the banking sector is on the relationship between competition and stability. This paper uses the Barth et al. (2013) database, which presents data on regulations for 180 countries obtained from surveys conducted in 1999, 2003, 2007 and Furthermore, competition measures (H-statistics) from Sun (2011) will be used as well. Combining these datasets on regulation and competition with bank observations on bank stability from 12 different countries between 1999 and 2012, this master thesis will empirically answer the following research question: What is the impact of regulation on the relationship between competition and stability in the banking sector? Furthermore, the existence of the expected trade-off between competition and stability will be tested as well. Additionally, this thesis will also contain analysis of various categories of regulations and comparisons between countries. In order to help answering this research question, this study is organized as follows. In the next section an overview regarding the current state of literature in the field of bank competition, stability and regulations in banking will be given. The third section will present the hypotheses development of this research. Subsequently, the fourth section will contain the methodology of this research, which will present the empirical method that will be followed in this research as well as information on the data 5

6 collection and sample selection. After that, the fifth section will present the empirical results of this thesis. Subsequently, in the sixth section conclusions based on the preceding results will be drawn. In addition, economic implications, limitations and recommendations for future research can be found in this chapter as well. 2. Literature review In this section, an overview on the existing literature on the competition and stability relationship will be given first. In addition, the first part of this section also provides information on previously used methods for measuring these two variables. The second part of this section will cover regulation. It will give an introduction to regulations used in the financial sector, an overview of earlier research on the effect of regulations on bank stability and methods of measuring regulation. 2.1 Competition and stability Two views on the competition-stability relationship Competition has an important role in the policy debate on the stability of the banking sector. The 21 st century began with years of relative stability but recent events in the financial world have made the competition-stability debate more relevant. The theory on this topic can be distinguished into two views: the competition-fragility (sometimes called charter-value view) and the competition-stability view. The first view says that banks that experience strong competition may lose market power and feel more pressure on profits. This results in higher incentives for taking on more risk in order to increase their returns and therefore a less stable, or fragile, banking sector (Carletti & Hartmann, 2002). This would imply that there is a trade-off between competition and stability. This view is supported by Keeley (1990), who found that increased competition caused bank failures in the U.S. in the 1980s. Additionally, Jimenez, López, and Saurina (2007) found evidence for the existence of a negative relationship between loan market power and bank risk in Spain. Which implies that, supporting the competition-fragility view, more competition is associated with less stability. More evidence for this view is provided by Berger et al. (2009), which concludes that their results are consistent with the competition-fragility view because they found that banks with more market power have less overall risk exposure. Additionally, Beck, De Jonghe and Schepens (2013) also found a positive and significant relationship between market power and stability. They tested the effect of the Lerner index as a proxy for market power on the Z-score as a proxy for bank stability. Nevertheless, Berger et al. (2009) stress that they also found some support for the fact that market power increases loan portfolio risk, which is explained by the competition-stability theory. The latter effect is the opposite of what Jimenez et al. (2007) found for the Spanish banking sector and supports the 6

7 competition-stability view. Important to remark, as can be derived from the results of Berger et al. (2009), is that these two views on the competition-stability relationship do not necessarily need to be each other s opponent because if competition decreases the risk of loan portfolio, the overall risks of a bank does not have to decrease. Earlier work of Berger, Demirgüç-Kunt, Levine, and Haubrich (2004) already concluded that more competition in the banking sector is good from a social perspective. Moreover, Demsetz, Saidenberg, and Strahan (1996) studied the effect of franchise value on risk taking. They describe franchise value as the present value of streams of income that a firm is going to earn. Firms with high franchise value are associated with less risk taking due to there is a more to lose for them (Demsetz et al., 1996). High franchise value can be obtained from two sources. First, it can be captured from efficiency differences or other bank related sources. Second, franchise value can be captured from limitations on competition caused by regulations. As one can see, franchise value is closely related to market power and competition, which suggests that low competition is related to more franchise value and less risk taking. Hence, Demsetz et al. (1996) supports the competitionfragility view as well. Additionally, Beck, Demirgüç-Kunt, and Levine (2006,) empirically tested the effect of bank concentration and bank stability covering the period and found that, consistent with the competition-fragility view (or as they call it, concentration-stability view), crises are less like in more concentrated banking systems. Even after adding control variables such as bank regulatory policies and macroeconomic factors to their model, their findings hold. On the other hand, the competition-stability view, which is more recently developed, says that in case of less competition, banks have more market power or maybe even have monopolistic power. In this concentrated market, banks use their market power by charging higher interest rates for loans. As one can see this makes it harder for customers to repay, increases the credit risk the bank faces and therefore the banks position will be less stable. In this case, the concentrated banking system enhances fragility, in contrast to more competitive banking systems in which many small banks operate (Boyd & De Nicolò, 2005). Their view is supported by Caminal and Matutes (2002), who show with help of their model that less competition is associated with higher probability of failure for loans. Moreover, if banks operate in a market with less competition, caused by consolidations, and have much market power, they can be seen as too-big-to-fail. This means that they will be saved by the government, if the bank fails. In this case, they have no incentives to be conservative in risk-taking, which leads to instability of the bank (Mishkin, 2002). This would imply a positive relationship between competition and stability, since less competition leads to more risk taking and thereafter less stability. More studies empirically found proof for a negative relationship between bank market concentration and risk taking, supporting the competition-stability view (Boyd et al., 2006; De Nicolò & Loukoianova, 2007). More support comes from Schaeck, Cihak, and Wolfe (2009), they studied whether competitive banking systems are more stable or not, using the Panzar and Rosse (1987) methodology, which will be explained in further detail later on. They found that banks that experience 7

8 more competition have lower likelihood of failure, suggesting that policies that improve competition may increase stability. Surprisingly, Beck et al. (2006) found, next to their evidence supporting the competition-fragility view by testing the effect of concentration on stability, proof consistent with Schaeck (2009) as well. They also found evidence which suggests that more competition (measured by entry and activity restrictions) leads to more stability. This finding raises doubt about the relationship between concentration and competition, which will be discussed in In addition, the topic of competition restrictions will be explained in more detail in the Regulation paragraph of this section. Berger et al. (2009) criticizes the empirical work of Boyd et al. (2006) and Schaeck et al. (2009). About Boyd et al. (2006) they argue that, in spite of the significant regression results, the coefficient describing the effect of concentration on stability is almost zero. The critics against Schaeck et al. (2009) held that the H-statistics, which are derived from the Panzar and Rosse methodology, are from the Claessens and Laeven (2004) study, which used a different dataset. Summarizing the earlier research on the competition-stability relationship, Beck (2008) states that, in line with the theoretical predictions, empirical results show ambiguous results on testing the relationship between competition and stability of banks. This is in line with the OECD report Bank competition and financial stability from Results of studies in various countries show a negative relationship. Nevertheless, most of the cross-country studies show a positive relationship. This is in line with expectations of non-financial markets, which are that competition causes a more efficient market and therefore more stability. Beck (2008) concludes that the tentative conclusion of this paper is that competition per se is not detrimental for banking system stability in a market-based financial system with the necessary supporting institutional frameworks (p. 21). As remarked earlier, Berger et al. (2009) also found evidence supporting both views. In addition to this two-piece proof, Carletti, Hartmann, and Spagnolo (2002) and Beck et al. (2006) found evidence for both views as well. Additionally, Beck et al. (2013) found significant cross-country heterogeneity in the competitionstability relationship. Varying from significantly negative to significantly positive relationships between market power and stability. Although, they argue that the evidence supporting the competition-fragility view dominates the evidence supporting the competition-stability view. In addition, Carletti et al. (2002) investigated the impact of mergers on stability in the banking sector, and found, as expected, that mergers lead to less competition. They found evidence for both views on the competition-stability relationship too. First, mergers tend to increase the market power of the banks, which causes less need for taking risk. The effect of this is expected to be that the banking sector would become more stable, and is consistent with the competition-fragility view. Secondly, the 1 This report can be retrieved from the following link: 8

9 merging banks become even larger and therefore become more important to the financial system. This would worsen the too-big-to-fail problem, which could create agency problems and less stability. This effect is consistent with the competition-stability view. This thesis was already referring to Mishkin (2002), who argues for existence of this second effect as well. In addition to this, Vives (2010) says that merger policies should have in mind the optimal degree of competition. Furthermore, Allen and Gale s working paper (2004) stresses that the competition-stability relationship is more complex than one would think. Their results do not give one clear answer. They explored which levels of competition and stability are efficient for the banking sector as well. Additionally, Vives (2001) argues that both excessive competition and excessive market power are a threat for the banking sector, depending on the regulatory instruments which are used in the market. Suggesting that both the competition-fragility view and the competition-stability view can be the case. He argues that strong regulatory structured countries will flourish with high levels of competition, whereas weak regulatory structured countries should lessen competition. Another view in this field comes from De Nicolò and Lucchetta (2001), who stress that whether perfect competition or imperfect competition is optimal for stability depends on the effect of technological intermediation banks use to screen borrowers. They say that their work goes beyond earlier research, which was impeded by limitations. As can be derived from the preceding overview of theory on the competition-stability relationship, one could see that earlier research does not give an unambiguous explanation. Multiple studies give evidence for both views or explain that there are conditions on which the effect of competition on stability depends. According to earlier studies, these conditions also contain regulations, which will be discussed later on in this literature review section Competition and concentration As can be read in the overview of the two views describing the competition-stability relationship, both effects are often explained using the concept of concentration. Generally it is believed that more competitive markets are less concentrated and less competitive markets, or even monopolies, enhance concentration. This assumes a negative relationship between competition and concentration. This assumption is useful for measuring competition, since if this hypothesis holds, concentration can be seen as a proxy for competition. Bikker and Haaf (2002) empirically found proof for this assumption while examining competition (using the Panzar and Rosse (1987) metholodogy) and concentration (using various k-bank concentration ratios and the Herfindahl index). They found that systems with few large banks can limit competition, suggesting the conventional negative relationship between concentration and competition. 9

10 Nevertheless, more recent studies did not find evidence proving this hypothesis (Claessens & Laeven, 2004). Moreover, they even found evidence for a positive relationship between competition and concentration and some indications associating more competition with a decreasing number of banks in a market. Furthermore, Beck (2008) argues that while seemingly opposing trends, consolidation does not necessarily imply less competition, as such consolidation can take place across different business lines or markets or create fewer, but more competitive players (p. 5). His idea is consistent with Claessens and Laeven (2004), which indicates that concentration measures are a noisy proxy for competition. More evidence for this concept is provided by Beck et al. (2006), finding a positive relationship between competition and stability as well as between concentration and stability. Furthermore, Matutes and Vives (1996) argue that concentration is no appropriate proxy for competition. The studies which are presented above cast doubt whether competitiveness can be gauged by concentration measures or not. This is the reason why this research will not use concentration ratios or market structure measures for measuring competition, as will be described in the next paragraph and in the methodology chapter Measuring competition and the Panzar-Rosse model As can be derived from the preceding paragraph, measuring competition (as well as stability) is not really straightforward. According to Beck (2008), this is the reason why the discussion on the relationship between bank competition and stability have been made difficult. Considering the critics against market structure measures like concentration ratios, the Lerner index and the Herfindahl index, this study will use H-statistics as a proxy for competition. The H-statistics can be obtained from the Panzar Rosse (1987) methodology, measures the reaction of output to input prices and is already used in studies of Claessens and Laeven (2004), Bikker, Spierdijk, and Finnie (2006), Schaeck et al. (2009) and Sun (2011). Built upon Rosse and Panzar (1977), Panzar and Rosse (1982, 1987) constructed a methodology based on bank-level data. It uses the extent to which a change in factor input prices is reflected in revenues earned by a specific bank, in order to assess the level of competiveness in banking. As one can see, this method includes the actual behavior of banks. The H-statistic is calculated by summing up elasticities between input and output prices and indicates this level of competitiveness. So the H- statistic measures the ability of banks to pass on increasing costs to customers. Originally, Panzar and Rosse (1987) calculate the sum of the factor prices elasticities in the Panzar-Rosse model as follows: ( ) where R is the revenue function, is the input factor i and is the sum of the factor price elasticities (the H-statistic). This H-statistic can be interpreted as follows: H 0 indicates a monopoly, 0 < H < 1 indicates monopolistic competition and H = 1 indicates perfect competition. In case of a monopoly the 10

11 H-statistic will be negative because an increase in input prices will increase marginal cost, reduce equilibrium output, and consequently reduce total revenues. In all other situations the H-statistic will be positive because some of the input increase, or even all of the input increase in case of perfect competition, will be positively reflected in the output. Sun (2011) and Claessens and Laeven (2004) follow the Panzar and Rosse (1987) approach in order to asses banking competition. They estimate the H-statistic based on the reduced-form bank revenue equation: ( ) ( ) ( ) where is the ratio of gross interest income over total assets as the proxy for output price of loans. is calculated as the ratio of total interest expenses to total deposits and money market funding, as proxy for input price of deposits; is the ratio of personnel expense over total assets, as the proxy for labor cost; is the ratio of other operating expenses over total assets, as the proxy for input prices of equipment and other fixed capital.,, and are the ratio of equity over total assets, the ratio of net loans to total assets and the total assets respectively, which are used as the control variables for bank specific effects. Each coefficient (, which is an measure of elasticity between input and output price, is estimated by pooled OLS regression. The H-statistic, which is the sum of the elasticities can be calculated as follows:. Sun (2011), even expanded this model to examine the H-statistics for each country for 3 time periods ( , and ). These steps will not be discussed in this study in further detail. Sun (2011) does this in order to examine the effect of the Euro and the recent financial crisis on banking competition. Drawing conclusions about the general competitiveness in banking industries, Claessens and Laeven (2004) find the H-statistics of 50 countries generally varying between 0.60 and 0.80, which suggest that this industry is best described as monopolistic competition. Furthermore, they do not find any pattern among the countries. Compared with Claessens and Laeven s (2004) H-statistics, Schaeck et al. (2009) found lower average H-statistics, with variation between and Senegal is the only country for which they found a H-statistic indicating monopoly and all other countries are estimated to experience monopolistic competition. Additionally, Bikker and Haaf (2002) find that the resulting H- statistic provides strong evidence that the banking markets is the financial world are characterized by monopolistic competition, but perfect competition cannot be ruled out in some cases (p. 2210). Furthermore, Bikker et al. (2006) found that monopoly cannot be rejected in 28% of the countries and that perfect competition cannot be rejected in 38% of the cases. They found more variation among H- statistics of countries compared with other studies. They conclude that monopolistic competition applies to almost every of the 101 countries in their sample and found an average H-statistic of

12 In addition, Sun (2011) found H-statistic for 12 countries over 3 period varying between 0.27 and The H-statistic of 0.27 was measured for the United States over the period, whereas the H- statistic of 1.02 was found for Ireland over the period. Sun (2011) concludes that a small but significant decrease in competition is found after the EMU. Furthermore, the results show that after the introduction of the Euro, competition levels in banking have converged within and among Euro countries. Moreover, Sun s (2011) results indicate the negative impact the financial crisis has had on competition. This thesis will use the H-statistics which Sun (2011) provides, as will be further discussed in the methodology section Measuring stability As Beck (2008) mentioned, also measuring bank stability is not simple. Researchers often measure stability with the distance to bankruptcy. The Z-score is an inverse proxy for the firm s probability of failure and is used in Boyd et al. (2006), Berger et al. (2009), Laeven and Levine (2009) and Beck et al. (2013). The Z-score is the sum of capital-assets ratio and return on assets, divided by the standard deviation of return on assets and will be calculated as follows: ROA is the rate of return on assets and is calculated as follows:. CAR is the capital adequacy or capital-asset ratio, which is the ratio of equity to assets and can be calculated as follows:. The resulting Z-score proxies the number of standard deviations of return on assets the bank is away from bankruptcy, so you could say that a higher Z-score indicates a higher banking stability. This high Z-score can be achieved by high return on assets, high equity ratio and low volatility of return of assets, implying that increasing net income, increasing the equity ratio and having stable return on assets will stabilize a bank and decreases overall risk. Furthermore, caused by negative income or equity, this Z-score can be negative as well. A negative Z-score indicates that the stability is even worse. Nevertheless, some studies use alternatives in measuring stability. Berger et al. (2009) for instance uses, aside from the Z-score, the ratio of nonperforming loans and the capital ratio as proxy for banking stability as well. Beck (2008) however argues that the ratio of nonperforming loans measures credit risk and is not related to the likelihood of failure. Additionally, Berger et al. (2009) use the capital ratio for measuring stability because they think it indicates the banks effort to control risk. Other studies used indicators of a systematic crisis as a proxy for instability (Beck et al., 2006; Demirgüç-Kunt & Detragiache, 2002; Schaeck et al., 2009). Defining a systematic banking crisis as a situation in which regulators or governments are intervening. This thesis will use the Z-score as a proxy for banking stability, as will be further explained in the methodology section as well. 12

13 2.2 Regulation Effects of regulation on competition and stability The effects of regulation on bank stability as well as its effect on the competition-stability interplay is a field of research on which less literature is available than on the competition-stability relationship. In his research, Vives (2010) gives the implications of an analysis of regulation and competition. He tries to answer the question whether the competition-stability trade-off can be regulated away or not and found that the intensity of competition could determine the optimal level of regulation. In addition, he stresses that this fine-tuning of regulation is very complicated and that coordination of regulation and competition policy is needed. Furthermore, Carletti (2008) studied the literature on competition, stability and regulation in order to answer the following questions: How does competition influence the effectiveness of the regulatory tools aiming at preserving stability? Can regulation correct the potential negative effects of competition on stability? (p. 451). According to Carletti (2008), the banking system should be regulated to avoid the negative consequences of intense competition, assuming the theory that predicts instability when the market experiences a high degree of competition. This can be done by a direct approach, which suggests ceilings on interest rates and entry limitations. In addition, reducing the negative effects of competition can be done by implementing capital requirements or risk-adjusted deposit insurance premia. On the contrary, Barth et al. (2001) show that a negative effect of intervention in the financial market is that when assets of banks are controlled by state-owned banks, the financial development, the development of the other sectors and the stock market will be impeded. Moreover, Barth, Caprio, and Levine (2004) stress that there is also discussion about state ownership of banks. Opponents argue that there is a lack of incentives for governments which impedes the efficiency (Shleifer & Vishny, 2002). Their view is supported by evidence which shows that government ownership leads to less economic development and efficiency (Barth, Caprio, & Levine, 2001; La Porta, Lopez-de-Silanes, & Shleifer, 2002). However, both papers do not cover each country and the availability of information varies across countries. In addition, Barth et al. (2004) improved their earlier research and did not find evidence supporting their earlier research. Berger et al. (2004) agree with Barth et al. (2001) and La Porta et al. (2002) and associate government bank ownership with les financial stability. Furthermore, they found that restrictions of competition are associated with poor economic performance as well. Their findings are supported by Beck et al. (2006), who found that banking systems with more entry applications denials experience increasing probability of a systematic crisis. This would imply that less competition is related to less financial stability, which is consistent with the competition-stability view which was discussed in the previous paragraph. Possible competition restrictions are foreign bank limitations and other requirements for banks to get a license, which are both included in the Barth et al. (2013) database. Claessens and Laeven (2004) provide empirical evidence suggesting that foreign 13

14 bank entry limitations obstruct competition and is an effective competition restricting instrument. On the other hand, Vives (2001) argues that countries with weak institutional structure should moderate the intensity of competition, which can be done by restrictions of competition. Furthermore, Barth et al. (2001) and Beck et al. (2006) found that tight restrictions on securities, real estate and insurance activities in the banking sector are related to more inefficient banking and higher crisis likelihood. Their findings are explained by Laeven and Levine (2009), who say that the reason for this effect is that restrictions in non-lending activities reduce the utility of owning a bank. This gives shareholders an incentive to make riskier decisions in order to compensate for the return they would have gotten when the non-lending activities were not prohibited by the government. In addition, Beck et al. (2013) found that activity restrictions can possibly amplify the negative effect of competition on bank stability. Another disadvantage of restricting banking activities is presented by Claessens and Klingebiel (2001), who say that these restrictions prohibit economies of scale and scope. Furthermore, Claessens and Laeven s (2004) study also found that banking systems with tight activity restrictions are experiencing less competition. On the contrary, Boyd et al. (1998) argue that this broadness of banking activities causes increasing risk-taking and worsens the moral hazard problem. They argue that universal banking does not provide efficiency advantages over commercial banking. Capital regulations seem to be a good financial instrument since capital is served as a buffer against losses, which increases stability and reduces the probability of failure. Nevertheless, Leaven and Levine (2009) state that also capital regulations might increase risk instead of reducing it. Koehn and Santomero (1980) state that, if this is the case, it is caused by the fact that loss of utility for shareholders caused by capital requirements tends to increase the riskiness in portfolio selecting. They studied the effects of bank capital ratio regulations on the portfolio behavior of commercial banks. As can be seen above, restrictions in activities and capital requirements might trigger a portfolio selection reaction, caused by the power of bank owners who are not willing to give up high returns. In these cases the purpose of bank regulation, which is of reducing the probability of failure and maintaining a stable banking-sector, fails. Instead, these regulations have the adverse effect of reducing stability. Additionally, with help of their model, Koehn and Santomero (1980) explain that this effect is worse for less risk conservative banks. Although they stress that the effect of regulations depends on the banks risk aversion level, they conclude that regulating bank capital through ratio constraints appears to be an inadequate tool to control the riskiness of banks and the probability of failure (p.1243). Moreover, Keeley (1990) explored the field of another regulation instrument, deposit insurance, and its effect on risk taking as well as the effect of capital ratios on bank stability. Deposit insurance is a financial instrument for decreasing the probability of bank runs (Diamond & Dybvig, 1983). Risk 14

15 adjusted deposit insurance premia could mitigate the trade-off between competition and stability which is predicted by the competition-fragility view (Carletti & Hartmann, 2002; Cordello & Yeyati, 2002; Hartmann, 2008; Matutes & Vives, 1996). However, Keeley (1990) found that, in line with effects above, also existence of deposit insurance influences shareholders to increase risk. He thinks that the deposit insurance system should be constructed differently, in order to reduce moral hazard for excessive risk-taking. This moral hazard problem is originated by the deposit insurance system through the fact that for depositors their money is save whether the bank is risk averse or not and the risk is shared with all banks in the system. This encourages insured banks to capture profits from added risk through adding leverage or investing in riskier assets without bearing the downside risk (McCoy, 2007). This has also major implications for competition in the banking-sector because banks do not have to compete with each other. Banks become homogeneous for costumers because their loss is insured no matter which insured bank they choose. In contrast, without deposit insurance, depositors would prefer save banks which would stimulate competition and banks would have to pay a risk premium. McCoy (2007) concludes that deposit insurance schemes can only protect depositors and keep control over moral hazard problems if a country fulfills strict requirements. In addition, Demirgüç-Kunt and Detragiache s (2002) empirical research on the effect of deposit insurance on bank stability found a negative relationship. Furthermore, they argue that deposit insurance schemes are more detrimental if the institutional environment is weak. In addition, Beck et al. (2013) found that more generous deposit insurance tends to increase the magnitude of the expected negative effect of competition on stability. As can be seen above, there is evidence and explanation which casts doubt on asset controlling by state-owned banks, government ownership of banks, restrictions on competition, restrictions on nonlending activities, the use of capital requirements and the use of deposit insurance schemes. Besides asset controlling by state-owned banks, all regulatory instruments above are directly measured in the database of Barth et al. (2013), which will be used in this research. The critics on the latter three regulatory instruments are caused by the change on risk-taking incentives of shareholders driven by those regulations. Moreover, Leaven and Levine (2009) empirically found that the effect of regulations on stability depends on the comparative power of shareholders relative to managers. According to Shleifer and Vishny (1986), are shareholders with power and incentives to change the behavior of the firm the ones who have larger voting and cash-flow rights. This implicates that regulations have an adverse effect on banks with large and powerful shareholders who have those rights. On the other side, if shareholders don t have sufficient power, their need of selecting a riskier portfolio will not be fulfilled and the regulations are likely to have a positive effect on the bank s stability. Furthermore, in their ongoing research on supervision, Barth et al. (2004) found that, based on their tentative results, instead of supervision and regulation by the government, they should rely on 15

16 guidelines that force accurate information disclosure, empower private-sector corporate control of banks and support corporate control done by private agents. They state that this works best in order to foster bank development and stability. These variables for private monitoring are also included in the database of Barth et al. (2013) Measuring regulation Based on their earlier work (Barth, Caprio, & Levine, 1999, 2001, 2004, 2006, 2008 and 2012), Barth et al. (2013) deliver a bank regulation and supervision database for 180 countries from 1999 to The four surveys on which this database is based was sponsored by the World Bank. Their work fills in the empirical gap of cross-country evidence on which government s policies work well and increase development and stability. Their survey provides information on each of the three Basel II pillars: minimum capital requirements, supervisory review and market discipline. In their research, they present 52 summary indices of bank regulation categorized in ten sections. Each index is based upon multiple questions, which are combined in an index due to the complexity and size of the survey. In their work they suggest that further research can combine their database with other datasets in order to test the effects of the regulations. To follow this recommendation, this master thesis will combine the Barth et al. (2013) database with data on competition and bank stability, as will be presented in the methodology chapter of this paper. 3. Hypothesis development After discussing the existing literature on competition, stability and bank regulation, this thesis will continue with constructing the hypotheses which will be tested in the empirical section. As can be read in the introduction, the main question that this research will try to answer is: What is the impact of regulation on the relationship between competition and stability in the banking sector? To help answering this question and investigating other determinants of bank stability, this thesis develops a set of hypotheses. First, the existence of the expected trade-off between bank competition and bank stability will be examined. As can be read in paragraph 2.1.1, theory about the effect of bank competition on bank stability shows ambiguous results. Nevertheless, the theory predicting a trade-off between competition and stability, the traditional competition-fragility view, has more empirical evidence, less critics and is more accepted. Therefore, I expect that competition has a negative impact on bank stability. Hence, hypothesis 1 will be: Hypothesis 1: competition has a negative effect on bank stability. Furthermore, this thesis will examine the effect of regulation on stability. These regulations in general, are created in order to maintain a stable banking system. According to Carletti (2008), regulations can 16

17 weaken the potential negative effects of competition on stability, and thus can have a positive impact on banking stability. This leads to the second hypothesis: Hypothesis 2: bank regulations have a positive effect on bank stability. However, when disaggregating regulation in subcategories, there is enough empirical evidence which weakens the belief that regulations are unambiguously good for bank stability. The preceding theory chapter provided evidence that tight restrictions on bank activities are associated with a higher crisis likelihood (Barth et al., 2001; Beck et al., 2006). This leads to the following hypothesis: Hypothesis 3: bank activity restrictions have a negative impact on bank stability. Theory on competition regulations also predicts that this financial instrument has a negative impact on stability (Beck et al., 2006), which leads to the following hypothesis: Hypothesis 4: competition regulations have a negative effect on bank stability. Additionally, the theory chapter discussed the effects of capital regulations, and presented empirical studies which casted doubt on the adequacy of capital regulations as a tool to control risk (Koehn & Santomero, 1980). From which the next hypothesis follows: Hypothesis 5: capital regulations have a negative effect on bank stability. Also the theory on the effect of deposit insurance schemes is explained in the previous chapter. It is believed that this financial instrument could mitigate the trade-off between competition and stability (Carletti & Hartmann, 2002; Cordello & Yeyati, 2002; Hartmann, 2008; Matutes & Vives, 1996). On the other hand, there is also evidence suggesting that deposit insurance schemes enhance moral hazard and encourages risk-taking (Keeley, 1990; Demirgüç-Kunt & Detragiache, 2002). Furthermore, the deposit insurance variable in this research measures the power of the deposit insurance authority and their degree of actions which are taken to mitigate moral hazard. Therefore, the next hypothesis will be: Hypothesis 6: deposit insurance quality has a positive effect on bank stability. In addition, this thesis will carry out a country analysis as well. According to Vives (2001), who argues that the relationship between competition and stability is influenced by regulations, countries with strong regulation structures will benefit from high levels of competition. Whereas countries with weak regulatory regimes should lessen competition. This leads to the following hypothesis: Hypothesis 7: countries with strong regulation structures experience a more positive effect of competition on stability. Important to remark is that testing hypothesis 7 will clarify the main question of this thesis since it covers the impact of regulations on the competition-stability relationship. Additionally, Beck et al. (2013) argue that with stricter activity restrictions the impact of competition on stability will increase. This thesis will test this indirect effect of activity restrictions on the competition-stability relationship, which leads to the following hypothesis: Hypothesis 8: countries with stricter activity restrictions experience a larger influence of competition on bank stability. 17

18 In addition, this hypothesis development chapter will also contain hypotheses about the effects on competition. Claessens and Laeven (2004) have empirically proven that competition restrictions have the expected negative effect on competition. The value of the variable competition regulation in this thesis is high when there are more restrictions. Consequently, the expectance of this desired effect of competition regulations leads to the following hypothesis: Hypothesis 9: competition regulations have a negative effect on competition. Claessens and Laeven (2004) also provide evidence suggesting that bank activity restrictions are associated with less competition, leading to the following hypothesis: Hypothesis 10: bank activity regulations have a negative effect on competition. Furthermore, as can be read in the previous section, moral hazard problems, which might be the effect of deposit insurance schemes, diminishes competition. This leads to the following hypothesis: Hypothesis 11: deposit insurance schemes have a negative effect on competition. 4. Methodology As can be concluded from the previous chapter, this paper will combine the Sun (2011) H-statistics as a proxy for competition, the Barth et al. (2013) database for measuring regulation and observations of banking fundamentals in order to construct stability. This master thesis sample will cover 12 countries in the period between 1999 and 2012 and will empirically answer the research question: What is the impact of regulation on the relationship between competition and stability in the banking sector? Furthermore, the existence of the expected trade-off between competition and stability will be tested as well. Additionally, these influences will be examined for each of the 12 countries as well. Subsequently, this research will also examine the effects of the each of the regulations components on stability and competition. This section will start with giving information about the data and measurement of competition, stability and regulation. This will be followed by the sample selection procedure and the steps this empirical study will follow. 4.1 Data Competition Competition measures will be implemented in the database by using the H-statistics which are presented in the IMF working paper of Sun (2011). As explained in the literature review chapter, the H-statistic is a measure for competition derived from the Panzar and Rosse (1987) methodology. A higher H-statistic indicates there is more competition. The data which Sun (2011) used to derive the H-statistics, was obtained from Bankscope as well. In Sun s (2011) working paper the average H- statistic of 12 countries is calculated for three periods: pre European Monetary Union ( ), 18

19 post European Monetary Union ( ) and post financial crisis ( ). These three periods were chosen because this research wanted to find out if the euro and the crisis had any impact on bank competition. Sun (2011) used at least 50-year observations for each H-statistic. The 12 countries for which the paper provides three H-statistics are: Austria, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, United Kingdom and United States of America. Sun (2011) chose to focus on these 12 countries because the 10 Euro-countries are the oldest ones and the UK and US are used as benchmarks. Another possibility was using the H-statistics of Claessens and Laeven (2004), but they calculated only one average H-statistic for the period. This makes it impossible to use this competition proxy as a dependent variable in describing stability. A quick comparison shows that the H-statistics of Claessens and Laeven (2004) are not significant different from the H- statistics of Sun (2011). Using the H-statistics from Bikker et al. (2006) would be less useful because that paper only provides one H-statistic measured of the period. Furthermore, with using the Bikker et al. (2006) H-statistics the most recent, and interesting, period would not be included in this research, as will be done with using the numbers Sun (2011) provides. Therefore, this master thesis will choose the H-statistics of Sun (2011), despite the limitation in the number of countries which were covered Stability The stability of the banks will be measured by the Z-score, which is the sum of capital-asset ratio and return on assets, weighted by the standard deviation of return on assets (Boyd et al., 2006). As already mentioned in the literature section of this thesis, the Z-score formula is as follows: ROA is the rate of return on assets of bank i in country j at time t, and is calculated as follows:. CAR is the capital adequacy or capital-asset ratio, which is the ratio of equity to assets bank i in country j at time t, and can be calculated as follows:. Beck (2008) states that: the resulting ratio indicates the number of standard deviations in return on assets that a bank is away from insolvency and thus the likelihood of failure (p.8). So the Z-score can be seen as the inverse of the probability of insolvency, a higher Z-score indicates that the bank is more stable. As can be seen from the previous formulas, the yearly total assets, net income and equity are essential in calculating the Z-score. The information of these bank fundamentals is obtained from the Bankscope Financials database (via Wharton Research Data Services 2 ) and initially consists of the net income,