UNIVERSITY OF THE WEST OF ENGLAND

FACULTY OF BUSINESS AND LAW

Module Code: UMACTU-15-M

Module Name: Contemporary Issues in Accounting & Finance

LITERATURE REVIEW ON THE IMPACT OF MARKET POWER ON

FINANCIAL STABILITY: EVIDENCE FROM MALDIVES

Villa College
Faculty of Business and Management

Student Name: Fathih Nabeel

Student Number: S1600101

Word Count: 3298

TABLE OF CONTENTS
1 Introduction.........................................................................................................................................3
1.1 Background Information..............................................................................................................3
1.2 Research Questions......................................................................................................................3
2 Role of Banks in the Financial Stability..............................................................................................4
3 Relevant Theories and Debates............................................................................................................5
3.1 Competition-Fragility Hypothesis................................................................................................5
3.2 Competition-Stability Hypothesis................................................................................................5
4 Empirical Literature and Discoveries..................................................................................................6
4.1 Linear Relationship......................................................................................................................6
4.1.1 Market Power.......................................................................................................................6
4.1.2 Financial Stability................................................................................................................7
4.2 Non-Linear Relationship..............................................................................................................8
5 Summary and Conclusion....................................................................................................................9
References.................................................................................................................................................10
1 INTRODUCTION
The Global Financial Crisis (GFC) 2007-2009 was an eye-opening phenomenon that identified
key organizational and regulatory lax in the financial sector. It facilitated the spill-over of the
failure of key five institutions namely, Goldman Sachs, Merrill Lynch, Bear Stearns Morgan
Stanley, and the infamous Lehman Brothers (Duffie, 2019). Evidently, being the largest
investment banks, Securities and Exchange Commission also believes that these large institutions
were particularly powerful and was able to manipulate and breach their capital adequacy
requirements which stood above 20 (Inspector General of the Securities and Exchange
Commission, 2008), which were normally maintained below 10 (The Clearing House, 2016),
jeopardizing the financial stability of the economy.
The implications of GFC highlighted the influence of financial institutions which were
responsible for the downfall suggesting the predominant Market Power over the financial sector
and the global economy. This is caused by interconnectedness of the financial sector and the
global economy by means of bilateral relationships or common share of exposures through
funding of different sectors in the economy (European Central Bank, 2019). Hence, the
relationship developed between majority of the economy and the ability of the financial
institutions (mainly banks due to volume of funding for the businesses such as term loans)
intervene with the aptitudes of businesses operating in all the sectors of an economy creates what
is known as the “Contagion Effect” where the failure of banks transmit through the channels of
different sectors affecting the whole economy eventually effecting the stability of the financial
sector (ERSB, 2016).
1.1 Background Information
Correspondingly, the relationship between Bank Market Power and Financial Stability has been
picked up and widely researched. For instance, Moudud-Ul-Huq (2020) provides evidence on
this relationship, taking a sample of 1137 banks from BRICS countries for the period of 2000-
2015 and proves that large banks are more efficient than small banks and during GFC small
banks are less stable if the market is more competitive. On another note, Su et al. (2020),
considering the banks from China for the quarterly period from Q1:2004 to Q4:2019, implies
that the optimum financial stability could be achieved with the conduit of continuous
improvement in competition. Therefore, Maldives known for being a highly concentrated market
with 8 banks in which 1 bank is predominant; the area of research will help improve the
understanding of this phenomenon and grasp better understanding by taking the whole
population into account.
1.2 Research Questions
Therefore, the research questions for this dissertation will be as follows:
1. Does linear or non-linear relationship exist between market power and financial stability
in Maldives?
2. What is the current relationship (positive/negative)?
3. Is the result significant to prove the relationship?
2 ROLE OF BANKS IN THE FINANCIAL STABILITY
The commotion caused by GFC has signified the importance of banks in the financial system and
their vital role in maintaining sound financial development. Correspondingly, the economic
development also depends on a stable financial system. A financial system encompasses
institutions that disburses funds for investment purposes and are providers of finance and
payment systems for the economy (OECD, 2005). Although the structure of the financial system
differs from developed to developing economies; the system mainly consists of deposit taking
financial institutions, payment systems, Insurance companies, capital markets, money exchange
companies, remittance companies, regulatory institutions, and central banks. The efficiency of a
financial system is determined by the maintenance of excessive volatility to a limit where the
system can withstand calamities that they may face (Hussein, 2010). The calamites that could
cause a financial institution to fail include economic policy changes, bank runs, man-made
shocks, and natural disasters (Nosheen and Rashid, 2021).
The GFC to this date is known as the worst economic catastrophe since the 1930s Great
Depression. The severity of the shock was not the complexity rather the widespread and the
development into a global phenomenon. The forefront of the spread was realized by the bank
failures, stock market crashes and the reduction in market value of commodities and equities
(Kumar, 2014). Although, Europe and US had predominant capital markets; European central
bank and US Federal reserve had to inject USD 2.5 trillion of debt and asset to the credit market
making it the most significant monetary policy action in the world (Kumar, 2014). Similarly, G-
20 countries incurred fiscal cost equivalent to 2.8% of GDP and OECD countries debt was
equivalent to 100% of GDP (Kumar, 2014). Undoubtably, any effect from developed nations will
spill over to the developing nations as the financial systems around the globe are directly or
indirectly linked. The conduit of cross border financial shocks from developed nations are caused
by a change in risk-free interest rates or an impact to their market risk (Agénor and Silva, 2018).
Therefore, Agénor and Silva, 2018 illustrates the cross-border liabilities internationally and finds
that the most exposed institutions to spill over are banks which increases the financial
vulnerability.
(Source: Agénor and Silva, 2018)

3 RELEVANT THEORIES AND DEBATES

The debate on the impact of banking competition on the overall financial stability is ongoing
along with the relationship derived being inconsistent. Former view by Keely (1990) and Marcus
(1984) known as “competition-Fragility Hypothesis” or “Franchise/Charter Value” suggests that
greater bank market power is detrimental to financial stability. On the contrary, Boyd and De
Nicoló (2005) shows greater market power to have a positive impact to financial stability. Hence,
the debate revolves around these two main views.
3.1 Competition-Fragility Hypothesis
Although the competition-stability hypothesis is the modern perspective, the competition-
fragility hypothesis has accrued ample recent literature around the perception. Traditionally, the
perception of a trade-off exists between the efficiency of the banking system and the financial
stability (Alyousfi, Sahac and Rusa, 2020).
Marcus (1984) argues that a fall in charter value or the market power of banks would induce
risk-taking behaviour of banks to secure market rents or abnormal returns resulting in the
increase of insolvency in the banking industry. Similarly, Keely (1990) states that the anti-
competition restriction in place enhances the banks market power or enhances their charter value
resulting in the reduction in moral hazard to undertake excessive risks. Supporting this argument,
Hellmann et al. (2000) add that the banks incentive to take risks are demoralized by the incentive
to protect their franchise value.
Ariss (2010) further elaborates by linking the information asymmetry problem with the market
power. The argument contends that the banks with greater market power will be able to develop
stronger bonds with the customers reducing the information gap. This will help the banks to
differentiate high-quality from low-quality debtors. Hence, the quality of portfolio limits the
exposure to insolvency risk enhancing the financial stability. More recently, Huljak (2015)
conducted a study on 415 CEE banks finds arguments in favour of the traditional view, although
competition results in greater efficiency which is again offset by the stability losses. Study by
Phan et al. (2019) on 99 commercial banks from East Asia also support of the traditional view
which argues that the reduction in monopoly rents caused by greater competition increases the
asset risk, decreases capital adequacy of banks, reduces the abnormal returns and their charter
value. Hence, their ability to withstand economic shocks drastically fall endangering the overall
financial stability.
3.2 Competition-Stability Hypothesis
Alternatively, the modern view argues that the trade-off does not exist; rather, the relationship
between competition and financial stability is positive. Boyd and De Nicoló (2005) revisits the
traditional view by testing the monotonic relationship between number of institutions and their
risk-taking behaviour. The study encapsulates the implications of competition on moral hazard
where lower competition lends more power to the banks resulting in greater flexibility in
decision making. Therefore, banks will not be motivated to maintain competitiveness and raise
the lending rates resulting in greater default rates from the borrower’s side. Furthermore, moral
hazard also attributes to financial decision making where banks are perceived to be investing in
high-risk projects maximizing their returns amplifying the insolvency of the bank.
Before the development of the theory, Caminal and Matutes (2002) study based on entrepreneur
moral hazard and the probability of default first highlights the ambiguity discussed in
competition-fragility hypothesis. Essentially, the study identifies that banks only fail because of a
macro-economic shock and links the attributes of regular businesses to banks. Under this view,
the “Bad Management” hypothesis state that, owing to the security instilled by the market power;
banks become less efficient in maintaining the credit quality which makes the banks more
vulnerable to economy-wide shocks (Berger and DeYound, 1997; Wiliams, 2004). Similarly, the
“Moral Hazard” hypothesis covers the agency theory aspect where managers take excessive risks
without properly conducting due diligence because of inefficiencies (Jeitschko and Jeung, 2005).
Hence, policy makers ease the capital requirement to encourage competition; however, it is also
important to maintain a balance in competition as capital requirements for banks plays a vital
role in maintaining the stability (World Bank, 2012).

4 EMPIRICAL LITERATURE AND DISCOVERIES

During past couple of decades, extant empirical literature has surfaced investigating the
relationship between market power or competition and the stability in the banking industry
predominantly using quantitative data.
4.1 Linear Relationship
4.1.1 Market Power
Investigating the influence of market power on financial stability, Minh el at. (2020) uses 24
banks in Vietnam over a period between 2008-2017. Minh et al. (2020) defines market power as
the bank’s ability to influence the market prices which effects the competition. The research
utilizes Lerner index to estimate the bank market power and highlights several advantages of the
metric. Other calculations such as the Panzar-Rosse H statistic and market concentration ratios
are criticized for not being able to accurately measure the market power considering the varying
bank levels. Additionally, Lerner Index considers the bank specific metrics related to funding
and assets side of the banks which are different from general businesses. Finally, this measure
takes the geographical discrepancies such as labour, capital, and operational differences into
account to attain a more comparable proxy for market power. For this research, dynamic panel
data was used through fixed and random effect or two-step generalized method of moment
(GMM) proposed by Arellano and Bond (1991) and uses total loans and loan growth rate as
extraneous variables. The results show a negative relationship between bank market power and
financial stability suggesting that the increase in market share assists in the financial stability
supporting the ‘competition-stability’ hypothesis.
Similarly, Alyousfi, Saha and Md-Rus (2020) also utilizes Lerner Index to measure the market
power to link with financial stability and economic growth by taking 38 European countries from
2001 to 2007 and explains the different benchmarks for competition derived from this index. The
metric provides values between ‘zero’ to ‘one’. Value of zero implies perfect competition, one
implies monopoly and less than one implies oligopoly or monopolistic market considering
depending on how close it is to ‘zero’ or ‘one’. The key difference in methodology is the
utilization of two structural; which includes Herfindahl Hirschman Index (HHI) and
concentration ratio of leading banks along with two non-structural concentration; including
Lerner index and Boone Indicator. The results show an inverse relationship from utilizing both
non-structural measures (Boone Indicator and Lerner Index) and structural measures (HHI and
Concentration Ratio). However, like Minh et al. (2020), the criticism towards the concentration
ratio has been put forward along with the acknowledgement of accuracy in indices that utilizes
bank specific aspects. The research by Ijtsma, Spierdijk and Shaffer (2017) supports this view,
whereby Concentration ratio and HHI was used to determine the competition on EU-25 banks
during 1998-2014. The study uses fixed effect to regress the impact of competition on financial
stability controlling for macro-economic variable such as GDP and inflation to account for crisis
periods and bank specific controls such as Asset side ratios, interest margin and NPL ratios. The
results shows that the concentration ratios have little to no causal relationship with financial
stability supporting the former argument.
Ijaz et al. (2020) further contributes by adding that Herfindahl Index alone cannot be relied on as
a proxy of market power; on the other hand, also highlights that the non-structural matrices have
the tendency to take factors outside bank competition such as firms’ financial, performance and
growth. Therefore, the research utilizes the Boone Indicator as a measure of competition. The
measure captures the efficiency of the bank by associating the elasticity of income to marginal
costs. The higher the result, the greater efficiency prevails resulting in higher level of
competition. The study finds that the increase in market power increases economic growth and
therefore, increases the financial stability by using fixed effect and GMM on 38 European banks
from 2001-2017. Economic growth has been used as a moderating variable for various studies
including Caggiano and Calice (2016), who explains the importance of economic growth for the
development in finance sector and associates the decline in growth with the sluggish operations
of the financial institutions as evident from the crisis periods. However, the Boone Indicator has
also been criticized for limiting the competition measure whereby presuming that the high
concentration results in low competition and vice-versa (Maudos and Vives, 2019).
4.1.2 Financial Stability
The study by Bandaranayake, Das and Reed (2020) on 23 journals, a book chapter and 7 working
papers published during 2006 to 2014, identifies eight categories to measure the financial
stability. These include the Z-Score, financial crisis used as a dummy variable, Nonperforming
loans (NPL) and other measures that surround the spectrum of volatile of return such as
ROA/ROE and capital adequacy ratios. Amongst the journals, the most frequently used measure
for financial stability is the Z-scores whereby the increase in Z-scores indicate less chance for
default, thus promoting financial stability. The study utilizes meta-regression analysis formulated
by Zigraiova and Havranek (2016) and finds a positive relationship between market power and
financial stability supporting the ‘competition fragility’ hypothesis. Similarly, Phan et al. (2019),
also finds evidence supporting the traditional view by considering data from 99 commercial bank
in East Asia for the period of 2004-2014. This study utilizes the Z-score based on equity and
asset (ZROE and ZROA). The study also considers the efficiency and how the banks manage
their risks as bank-specific control variables as these factors heavily impact the bank’s solvency.
The research conducted by Santoso et al. (2020) studies the relationship between the market
power of banks and the level of risk taking by considering data from 2000-2016 for 265 publicly
traded banks in Asia. The study also utilizes ZROA to calculate the dependent variable reflecting
bank risk taking. The calculation is formulated by dividing average ROA and equity to total
assets by the standard deviation of ROA. This calculation has been also utilized by Lepetit and
Strobel (2013) for a research conducted on the bank insolvency risk. Additionally, ratio of loan
loss provision to total loans (LLP) has also been considered for the calculation of bank risk
taking which is like NPL ratio considered mentioned earlier. Also, to control for bank and
country specific factors that may affect the results, the study utilizes banks’ capitalization and
Financial Freedom to identify whether these factors affect the result. Using the dynamic panel
data, running two-step GMM estimation, the results show a positive impact of market power
over financial stability, performance and loan growth supporting the ‘competition-stability’
hypothesis. However, it is worth noting that the banks with high capitalization are stable when
market power increases and the role of market power is predominant in countries with lower
financial freedom. Interestingly, the control variables contribute to the question of inconsistency
in results as the impact for different countries differ due to the level of freedom.
Similar area has been investigated by Tan and Floros (2017), measuring the relationship of
market power by utilizing the Lerner index on the level of risk taking in the Chinese banking
industry. Instead of using the Z-scores, the study uses Translog function to estimate
inefficiencies which are then run by using a Granger-casualty test. Although the approach is
significantly different, the metrics are quite similar with credit risk calculated by the NPL ratio,
liquidity risk calculated by the ratio of liquid assets to total assets and capital adequacy ratio.
These are normally observed as control variables and the insolvency risk as the main proxy for
financial stability. Insolvency risk is calculated by cost, pure technical and scale efficiency which
assists government to narrow down the source of instability. Estimating the equations, the study
uses GMM and finds that Chinese banks are more insolvent where market power is prevails
supporting the ‘competition-stability’ hypothesis. However, the study also concludes that the
increase in insolvency and credit risk increases the efficiency of banks in a competitive market.
Conversely, Jiménez, Lopez and Saurina (2013) also using NPL ratio to measure credit risk
instead of Z-scores as a proxy to financial stability, finds results supporting the ‘competition-
fragility’ hypothesis. The study utilizes data from 107 commercial and savings bank from
Spanish banking industry for 14 years starting from 1988 and shows that the relationship is still
inconclusive.
4.2 Non-Linear Relationship
Ample literature accumulates on the linearity of the relationship between market power and
financial stability throughout the years. However, a more recent approach has shed light on the
possibility of the research area being inconsistent is the coexistence of both positive and inverse
relationship. The paper postulated by Barra and Zotti (2020), conducts the similar research in the
Italian banking industry from 2001-2012 utilizing the Z-scores as a conduit for financial stability,
market power based on the share of loans and uses stochastic frontier approach proposed by
Kumbhakar, Lien and Hardaker (2014). The highlight of the result entails the U-shape depending
on the market share where the increase in market power in a low concentrated market increases
the financial stability; whereas high concentration is detrimental towards financial stability
where market power prevails. Another research from 14 Asian countries from 2001-2010 by Fu,
Lin and Molyneux (2014), utilizing Z-Score, Lerner Index, bank-specific-factors such as LLP
and country-specific factors such as GDP also illustrates that both theories can exist
simultaneously. The result from GMM shows that the increase in pricing power increases the
bank stability; however, reverses in a more concentrated market. Finally, the research by Liu,
Molyneux and Wilson (2012) also considering Lerner Index, Z-Scores, and economic factors
such as GPD and unemployment rate and bank specific factors such as log of total assets and
cost inefficiency finds evidence for the non-linearity of the relationship. The GMM estimator
establishes non-linear relationship where increase in competition improves the financial stability
but increases the financial instability in an uncompetitive market for banks from 10 European
banks for the period of 2000-2008.

5 SUMMARY AND CONCLUSION

The extant literature reviewed has assists in understanding of the research questions and areas to
emphasis in my dissertation. The first highlight was the underlying theories from traditional and
modern perspective. The former highlights the financial fragility caused by the decrease in
market power caused by dilution of profits and information asymmetry. Latter identifies the
positive reaction to financial stability caused by the increase in competition due to the increase in
efficiency of banks.
The current literature is inconclusive on the relationship where different aspects considered for
the methodology affects the result. For instance, the metric used to calculate the competition
varies amongst the researchers. Most notably concentration ratios such as HHI and non-structural
metrices such as Lerner has been utilized. As a proxy for financial stability, Z-scores and
different accounting risks has been calculated along with the measures identifying efficiency.
Finally, bank-specific variables such as total assets and LLP and country-specific variables such
as financial freedom and GDP has been commonly used to control for any inconsistencies.
Therefore, following the methodology of past research such as Fu, Lin and Molyneux (2014), I
would like to contribute by considering all the banks in Maldives using the metrices mentioned
above.
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