BANK COMPETITION ON FINANCIAL STABILITY 1

What is the Impact of Bank Competition on Financial Stability in the EU Area?

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Motivation and Questions

According to CNBC, the non-performing loan's amount is estimated to be over 1 trillion

euros. This has been facilitated by a lack of trust and confidence from investors, which questions

the banking solvency's ability, which hinders access to funding. The European Union has

exhibited recent developments mandating the nations towards the espousal of the Single

Resolution Mechanism (SRM). Different studies conclude diverse ideas regarding the impact of

non-performing loans on the union. Some ponder non-performing credits as a substitution for

fiscal steadiness. Therefore, the studies explore the influence of banking rivalry on the loans, as

mentioned above. However, the studies rely on limited data to draw the inferences hence

impossible to rely on the information provided. Therefore, the loopholes exhibited in the studies

have motivated the quest to examine the influence of the banking rivalry on European Union

with the aid of data from 1998-2011 and existing literature to draw the substantial-conclusion

that can be used in establishing policies deemed fit to reduce the growing number of non-

performing credits in the union. The study is divided into several sections, including literature

review, methodological framework, data, results in discussion, and policy implications. The

multifaceted contribution of the study to the existing literature is indispensable. In essence, the

thesis establishes its claim by integrating the Lerner Index and to quantify banking rivalry and

non-performing credits to measure financial stability. Furthermore, the study considers data from

all the 28 affiliates of the European Union as well as data covering 13 years based on macro-

prudential policies incepted in the union (Bikker & Bos, 2018). Besides, the thesis integrates

various variables to establish substantial inferences.

The development of the study is based on the questions, is there a substantial measure to

launch the correlation between banking rivalry and financial stability considering data from all
BANK COMPETITION ON FINANCIAL STABILITY 3

the b28 members? Can a solid solution be incepted to curb the increase of non-performing loans

in the arena? Does rivalry affect cooperative banks' stability? Is financial stability positively or

directly correlated with the competition?

Literature Review

Several authors have confirmed the inherent link between financial stability and banking.

Beck investigated on the same analogy by conducting both hypothetical and pragmatic studies

regarding the same topic. Beck's hypothetical prose provides disparities between two central

theories. One theory argues that banking with high concentration levels exhibits low competition,

which implies more financial stability in the union. This implies that competition and financial

stability are negatively correlated (Beck, 2018). Thus, an increase in competition level lowers

fiscal steadiness as well as low concentration levels in the finance sector. The other theory argues

that less rivalry and more concentration in the finance structure lowers the banking stability.

Both opinions are built from several theories establishing probable connection amongst the

variables as mentioned above. Mainly, the researcher relies on Z-scores as a substitution for

monetary solidity (Beck, 2018). Ideally, Z-scores measure the default risk of the bank to

establish financial stability. Non-performing loans (NPLs) ratio is used as a metric to amount

bank and credit risk-taking. However, the metrics used are insufficient in measuring the failures

of a bank. Other studies rely on concentration ratio to measure competition while others Lerner

Indices and H-statistics. Furthermore, regulatory measures like entry barriers and requirements

are used as substitute measures of competition.

Beck's study inferences that bank-level empirical studies are insufficient in the study of

competition, banking stability, and concentration, thus they cannot be used to draw a positive or

negative correlation among the variables (Beck, 2018). However, Beck concludes that higher
BANK COMPETITION ON FINANCIAL STABILITY 4

concentration may not necessarily be resulted in a lower competition level. Multifaceted studies

imply that competition and stability are positively correlated; thus, concentration ratios are

insufficient quantifiers of rivalry compared to other metrics.

An indispensable study of this paper was conducted by Anginer et al. in the quest to

establish the connection between risk-taking bank behaviors and competition. The study relied

on a sample taken from publicly traded banks from 1997-2009. The sample was obtained from

63 states; thus, inferences can be drawn at a lower significance level (Fungáčová et al., 2014).

Anginer et al. focused on systematic risk instead of personal bank risk in the quest for addressing

macro-prudential policy matters. Thus, the study dispensed bank-level data and Z-scores

(Anginer et al., 2012). Profitability measure was used as a metric to calculate the connection

between Z-scores and Lerner Index. Besides, R-squared was used to enhance the authenticity of

the study. Macroeconomics and bank-level determinants were used as controls. To control for

economic expansion, Gross domestic product (GDP) per capita was applied.

Similarly, financial structure and development control was controlled by stock market

capitalization and country size (Anginer et al., 2012). According to the results from the study,

competition and stability exhibited a positive correlation. This implies that higher rivalry levels

result in higher risk diversification level, which indicates to larger steadiness. Besides,

systematic steadiness is negatively linked with weak government ownership and supervision of

banks.

Another relevant study to this research was conducted by Heimeshoff and Uhde,

considering balance sheet data emerging from 25 EU banks on the financial steadiness period

1997-2005. Similarly, Z-scores were applied as metrics to analyze financial stability. GDP per

capita, Interest rates, and GDP growth were applied as the major macroeconomic determinants.
BANK COMPETITION ON FINANCIAL STABILITY 5

In this case, the net interest margin was used as proxy profitability, while loan risk and quality

were measured with loan loss provisions (Barnato, 2013). The deposit insurance system

controlled moral hazard while efficiency measured the cost-to-income ratio. The researchers

considered banks owned by the government to take additional risks due to moral hazards

connected to bailouts. After careful analysis of the results, the researchers established that

stability and concentration are negatively correlated. Also, banks owned by the federal were

concluded to be less stable (Garicano & Lastra, 2017). Similarly, GDP per capita, credit growth,

and capital regulations exhibited a positive correlation with stability.

Agoraki et al. (2011) investigated the impact of regulations on market power by

considering a data of 546 banks from 13 transition states. The sample size was huge, as some

banks were reported to have missing data on some areas (Prati & Schinasi, 2019). However,

similar results were established after conducting a state-level analysis (Alin & Capparru, 2011).

In this study, NPLs and Z-scores were applied as a risk-taking proxy, while the bank-level

Lerner Index was applied as a metric for measuring competition (Noman, 2017). Regulatory

indices developed comprised of agency supervisory power, activities' restrictions, and capital

stringency. Bank efficiency and size was controlled by total cost and assets to return ratio

(Agoraki et al., 2011). The monetary and economic environment was used to control interest

rates and GDP growth, while public and foreign ownership were both factored. Increased

regulations as a result of credit risk promoted the application of the GMM instrumental variable

approach (Blundell & Bond, 2018). The results indicated a negative relationship between NPLs

and market power (Howarth & Quaglia, 2013). Besides, risk-taking was observed to be lower

when market power was integrated with capital requirements (Arellano & Bond, 2013). Also,

direct risk can be minimized through the collaboration of sanctioned supervisory power
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mechanisms. Furthermore, the study established that combining greater market power with

activity restrictions lowers loan risk and chances of nonpayment (Agoraki et al., 2011). This

implies that restrictions and regulations are insufficient measures of reducing loan risk.

Louzis et al. (2012) explored on significant factors influencing NPLs in Greece. In this

study, the specific determinants of banking and macroeconomics were evaluated considering

quarterly data from nine of the largest financial institutions in Greece. The major macroeconomic

aspects factored in the study included interest rates, GDP, public debt, and unemployment (Casu

et al., 2012). Bad management is tested by considering the return on equity, which determines

whether resources are fully optimized (Cuestas et al., 2020). Moral hazard effects are assessed

through capital-to-assets while skimping and atrocious management is checked through the

institutions' expenses-to-income.

Similarly, the study controlled diversification and size by integrating each bank's total

assets and non-interest returns to the overall income (Louzis et al., 2012). The study concluded

that macroeconomic aspects determine Greece's NPLs. Thus, higher economic evolution results

to lower NPLs ratio and vice versa. Also, higher unemployment levels are accompanied by the

inability to repay debts, thus indicating higher NPLs levels (Carletti et al., 2012). Therefore,

crediting rates positively affect NPLs. Similarly, NPLs and Debt-to-GDP are positively

correlated (Louzis et al., 2012). The study concluded that bank-specific variables, including

efficiency and performance, are sufficient in the explanation of NPLs and lousy management.

Methodology

In the study, credit risk is quantified with NPLs. The computation of NPLs will be

obtained by dividing the total value of a nation's defaulting loans to the loan portfolio's total
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value. As a result, the following factors were established as the key determinants of NPLs.

Firstly, banking competition is considered as it is proven to have an inverse affiliation with

concentration and stability. Thus, an upsurge in banking rivalry results in a diminution in

concentration and less steadiness in the financial sector (Di Giorgio & Di Noia, 2014). This is

because firms will set affordable interest rates to attract a wide customer base. As a result, the

customers borrow more loans at lower interest rates, thus increasing NPLs.

The study uses the Lerner Index to examine the competition. This is because the metric

considers the bank's competitive behavior in setting interest rates and other services. Besides, the

index measures market prowess, whereby a higher number of Lerner index signifies a more

durable market influence. In this study, p is regarded as the price, while MC is the marginal cost.

Thus, Lerner index= (P-MC)/P. Also, Eurozone membership was considered as a dummy

variable in capturing the disparities between EU affiliation and other states.

In essence, the prolonged deflationary monetary policies in the Eurozone have increased

NPLs as banks have increased their loans to the market to enhance profitability since the interest

rates were low. Also, the study considers macroeconomic determinants, such as GDP growth,

inflation, and unemployment, to measure the ability of debtors to meet their financial obligations.

After that, banking sector-specific determinants were measured through return on equity

(Fiordelisi & Mare, 2014). Besides, higher efficiency was recorded when the cost-to-income

levels were low. Institutional and regulatory determinants were measured by the eradication of

corruption effects.

Data Analysis
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In the study, data from 28 EU affiliate nations was used spanning from 1998-2011.

Mainly, the data was sourced from the World Bank 2013 series. NPLs are regarded as the

dependent variable whereby the variables used were measured with the Lerner index. The

alternative proxy for banking rivalry is considered as Boone Indicator and Five-bank asset. The

study preserves the integrity of the existing research on GDP, inflation, unemployment rates, and

interest levels. The data obtained from World Bank 2013 was analyzed with the help of statistical

packages such as Stata and presented in the table below.

BANK COMPETITION ON FINANCIAL STABILITY 9

Discussion

The study mainly focuses on data from the 28 EU member states to explain the combined

variables and their effects on concentration, competition, and stability. In the study, NPLs are

used as a metric to study stability, while banking competition is measured with the Lerner Index.

The study concludes that higher market power results in higher NPLs ratio. Similarly, higher

rates of growth imply lower NPLs ratio. Therefore, the findings coincide with previous studies

on the topic. Besides, the results confirm that corruption levels result in higher NPLs in a nation,

thus contradicting the previous studies that pigeonhole developing economies have lower NPLs.

Thus, there exists a negative correlation between financial stability and competition. Besides,

NPLs are higher in non-Eurozone states. Also, lower capital is accompanied to higher NPLs

levels.

Conclusion

The 2007 financial turmoil implies that the banking sectors exhibit an inherent

connection across the globe. Therefore, when a nation's banking sector is affected, other nations

incur direct effects. This would facilitate the collapse of the global economy; thus, nations should

become a worker in conjunction to stabilize the financial sector rather than compete for interest

rates. This paper seeks to establish the impact of banking rivalry as well as Eurozone affiliation

on NPLs. The study concludes that higher market power results in an advanced NPLs ratio.

Similarly, higher rates of growth imply lower NPLs ratio. Therefore, the findings coincide with

previous studies on the topic. Besides, the results confirm that corruption levels result in higher
BANK COMPETITION ON FINANCIAL STABILITY 10

NPLs in a nation, thus contradicting the previous studies that pigeonhole developing economies

have lower NPLs.

References

Agoraki, M-E.K. Delis, M.D, and Pasiouras, F. 2011. Regulations, competitions, and bank risk-

taking in transition countries.

Alin, A. M., & Capparru, B. (2011). How does Eu banking competition impact financial

stability?. Electronic resource.–Access mode: http://www. opf. slu.

cz/kfi/icfb/proc2011/pdf/01_Andries. pdf.

Anginer, D. Demirgur-Kunt, A., and Zhu, M., 2012. How does bank competition affect systemic

stability. The World Bank development research group. Finance and private sector

development team. Policy Research Working Paper WPS5981

Arellano, M. Bond, S.2013. Some tests of specification for panel data: Monte Carlo evidence and

an application to employment equations.

Bank for international settlements

Barnato, K. 2013. "Bad loans at European banks hit $1.7 trillion" [Online] Available at

http://www.cnbc.com/id/101148313 [Accessed: 10/04/2014]

Beck, T., 2018. Bank completion and financial stability: Friends or Foes?

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the analysis of profitability, competition, and efficiency. Routledge.

BANK COMPETITION ON FINANCIAL STABILITY 11

Blundell, R., Bond, S., 2018. Initial conditions and moment conditions in dynamic panel data

models. Journal of Econometrics 87, 115–143.

Carletti, E., Hartmann, P., & Spagnolo, G. (2012, March). Bank mergers, competition, and

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Di Giorgio, G., & Di Noia, C. (2014). Financial regulation and supervision in the Euro Area: a

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