A general principle in banking supervision is that excess competition

among banks could result in probability of insolvency, thereby affecting

the stability of the banks. Liberalization of the banking system might
erode the franchise value of the bank, thereby encouraging them to
pursue riskier policies in order to maintain their profits (keeley,1990).
Greater competition also enables efficient banks to enter markets and
expand, displacing inefficient banks. At the retail level, competition
between banks is increased when customers can easily switch providers.

According to the proposal made by Boyd and de Nicolo, lesser competition

among the banks might encourage the banks to charge higher interest
rates on loans, which increases the credit risk of the borrowers. This
increase in credit risk might result in instability of the banks. If there is a
higher competition amongst the banks for loans and deposit markets
could help in reducing the borrowers credit risk and help in attaining more
financial stability. Allen and gale have shown than different models can
provide different results regarding the relationship between competition
and stability. As per Martinez-miera and repullo, lesser competition might
result in higher risks as the interest rates would be higher, thereby
resulting in higher defaulters, but argues that at the same time, it
generates more revenue for the bank from the non-defaulting borrowers
who pay a higher interest rate. As per their model, the relationship
between banks competition and stability could be U-Shaped ( i.e. with
increase in number of banks, probability of bank default initially declines

but beyond a point it increases).

The objective is empirically examined based on 3 different models,

namely franchise value model, risk shifting model and mmr model.
HOW DOES COMPETITION INCREASE STABILITY

6 reasons why competition is important

To enable the firms and households to get access to financial services

For the financial sector to function properly
Financial system stability
To manage financial intermediaries effectively
To improve monetary transmission policy through interbank market rates
For overall growth of industry and economic growth.

In this paper, we examine the mechanisms through which competition

impacts bank stability.
2 basic channels through which the competition impacts stability include
Competition increases instability by exacerbating the coordination
problems on liability and fostering bank runs.
Increasing incentives to take more risk on either side of the balance sheet,
thereby increasing the probability of failure

The financial crisis in 2007 identified bank funding structure and financial
innovation as some of the sources through which the competition would
impact stability in a negative way. Also other factors like derivatives, loan
sales, credit default swaps have been sources of instability in the financial
sector.
The overall contribution of this paper is that it shows empirically that
competition increases bank stability, and that the effect is due to the
decision that banks make to diversify their portfolios in response to the
competitive environment in which they operate.

Both Turk-Ariss (2010) and Schaeck and Cihak (2010b) focus on bank
efficiency as a possible conduit through which competition influences
bank soundness. Tabak et al. (2012) argue that bank size and
capitalization are the essential factors that explain the relationship
between competition and the risk-taking behaviour of banks. Beck et al.
(2013) however, suggest that an increase in competition will have a larger
impact on banks fragility in countries with stricter activity restrictions,
lower systemic fragility, better developed stock exchanges, more
generous deposit insurance and more effective systems of credit
information sharing. Our paper contends that competition pressurises
banks to adopt strategies to diversify and this decision affects bank
insolvency risk

Conclusion

The results show a positive and significant relationship between

competition and stability. More importantly, this positive and significant
relationship holds when risk adjusted profits are used as the dependent
variable. This means that greater competition in a banking sector
enhances stability. On competition and bank capitalization, the results
show that diversified banks that operate in a competitive environment
tend to hold relatively more equity capital though the result is relatively
insignificant. Our results also show that a competitive and diversified
banking system is associated with less risky loan portfolios.

The core finding is that competition increases stability as bank

diversification across and within both interest and non-interest income
generating activities increases. Furthermore, our analysis identifies a
channel through which competition affects bank insolvency risk in
developing/emerging markets. The results also comply with the
competition-stability view in the theoretical literature and are generally
consistent with prior empirical findings that banks that operate in an
uncompetitive banking industry are prone to originating riskier loans
which are detrimental to their stability.

The objective of this paper is to examine empirically whether the relationship between bank
competition and risk is linear, as suggested by both franchise value and risk-shifting models,
although with opposite signs, or is U-shaped, as in the MMR model.
Although this type of analysis can take into account quite different banking systems, this
benefit might come at the cost of a lack of comparability across variables, both dependent and
independent. Our focus on a single banking system avoids this concern.
Our results show that competition increases bank stability. This is because banks
make decisions to diversify their portfolio in response to the competitive environment
in which they operate. Furthermore, the results show that competition not only
improves stability, it also enhances bank performance measured by risk adjusted
return on both assets and on equity (RAROE).
On contestability, the results reveal that the regulatory initiative that requires high
regulatory capital and protects property rights reduces insolvency risk. The overall
contribution of this paper is that it shows empirically that competition increases bank
stability, and that the effect is due to the decision that banks make to diversify their
portfolios in response to the competitive environment in which they operate.