Correlation of Competition and Efficiency

The relationship between competition and stability is also ambiguous and dominated by two schools of thoughts in theoretical literature: “competition-fragility” and “competition-stability” hypotheses. The competition fragility hypothesis (also called as franchise value paradigm), states that increased competition among banks leads to greater banking risk-taking and thereby, greater financial fragility. This is because intense bank competition results in a reduction in market power as well as profit margin, which weakens the franchise value of banks. Therefore, in order to cover the losses from the decline in the franchise value, banks will have greater incentives to take on more risks for profits. This view is in literature theoretically modeled by Furlong and Keeley (1989) and Keeley (1990). Using a model of risk-taking by banks with two periods and two states, Keeley (1990) shows that as competition increases in the banking market, risk-taking by banks also increases and becomes contagious. Allen and Gale (2000) corroborate this finding in a model of competition and risk-taking aimed at demonstrating the agency problem.

They pointed out that when firms are debt-financed (e.g. deposits for banks), managers acting in the interest of the shareholders have an incentive to take excessive risk since the manager’s performance is assessed based on quarterly returns, with debt holders bearing the downside risk while the shareholders benefit from upside potential return. As a corollary, Hellman et al., (2000) noted that stiff competition leads to financial institutions making riskier investments in order to generate sufficient profits for shareholders or in order to maintain their market share, thereby engendering financial stability. Besanko and Thakor (1993) show that increased competition leads banks to take greater risk because of eroding the informational rents initiated from relationship banking activities. This leads banks to decrease their incentives to screen potential borrowers, thereby, resulting in decline in credit quality of banks. As a general view of this hypothesis, deregulation which results in more bank entry and competition, leads to greater fragility. Likewise, Murdock and Stiglitz (2000) assert that more competition with lower bank margins can have a negative impact on prudent behaviour of banks, thereby, resulting in more risk taking. The competition fragility hypothesis thus argues that increased competition leads to greater risk taking by banks and thereby greater fragility in banking system. In other words, higher levels of competition, increase instability risk.

The competition-stability hypothesis of Boyd and De Nicolo (2005) on the other hand, assumes competition in both loan and deposit sides of the market. Focusing on the deposit side of the balance sheet, it is assumed that banks can earn higher rents since they pay lower deposit rates in less competitive markets. However, in a moral hazard environment, as in Stiglitz and Weiss (1981), on the lending side of the market, banks can charge higher interest rates to borrowers in a less competitive market. The higher borrowing rates may enhance the risk-taking behaviour of banks and thus, leading to an increase in the default risk of banks. This view, which is also called the ‘risk shifting’ paradigm, generally suggests that higher levels of competition results in more, rather than less stability.

Martinez-Miera and Repullo (2010) extend the Boyd and De Nicolo model by introducing imperfect correlation across borrowing firms’ default probabilities. As in the Boyd and De Nicolo model, their model also covers “risk shifting effect”, in the sense that more competition leads to lower loan rates, lower default and bankruptcy risk and lower risk-taking by banks. However, because their model allows for imperfect correlation across firms, it suggests the existence of “margin effect”, which purports that lower loan rates decrease overall bank revenues, and therefore, this would probably lead to greater bank risk-taking and bank failures. Thus, the resulting net effect between bank competition and financial stability is not clear, since these two effects work in opposite directions. Specifically, based on Martinez-Miera and Repullo (2010) model, the margin effect is shown to dominate the risk-shifting effect in more competitive markets, implying that more competition in a market increases bank risk-taking, and thus, results in greater financial fragility. On the other hand, the risk shifting effect is shown to dominate the margin effect in a more concentrated banking market, suggesting that increased competition leads to lower bank risk-taking and bank failure risk in such markets.

In short, the competition stability hypothesis argues that competition improves financial system stability due to its effects on lowering lending rates thereby reducing probability of default and consequently systemic risk (Nicolo & Jalal & Boyd, 2006). Higher levels of competition therefore result in more (rather than less) stability.

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The relationship between competition and efficiency in banking is not so clear-cut and empirical findings are mixed. For instance, Beck and Hesse (2006) using bank-level data set on the Ugandan banking system during 1999-2005, found that market structure played a limited role in determining bank efficiency in Uganda. Instead, the found that bank-level characteristics, such as bank size, operating costs, and composition of loan portfolio explained a large proportion of cross-bank, cross-time variation in spreads and margins.

Banyen & Biekpe (2020) examined the causal relationship between bank competition and efficiency in five regional economic zones of Africa over the 2007–2014 period using data from 405 banks from 47 African countries. The results show a steady rise in bank competition and efficiency in Africa and the five sub-regional markets overtime. The results also support the quiet life hypothesis in Africa, especially in the East African Community, Arab Maghreb Union and Southern African Development Community.

Moyo (2018) investigated the relationship between competition, efficiency and soundness in the South African banking sector. The study used a data set of 17 local and international banks for the period 2004–2015 and stochastic frontier models to analyse efficiency. They found that the impact of competition on efficiency depended on the measure of competition used. When using the Lerner index there was a negative effect of competition on efficiency while the opposite was true when using the theoretically robust Boone indicator.

Buchs and Mathisen (2005) assessed the degree of bank competition and efficiency with regard to banks’ financial intermediation in Ghana. Using panel data, they found evidence for a non-competitive market structure in the Ghanaian banking system, which they opined could have been hampering financial intermediation. The authors argued that the structure, as well as the other market characteristics, constitutes an indirect barrier to entry thereby shielding the large profits in the Ghanaian banking system.

Schobert (2008) used quarterly data for Czech banks to investigate the relationship and causality between competition and efficiency. Using the Granger-causality-type analysis, the findings supported a negative causality only running from competition to efficiency. Based on the results, the author rejected the intuitive ‘quiet life’ hypothesis and concluded that a negative relationship existed between competition and efficiency in the Czech banking system.

Using a unique database for 74 countries and for firms of small, medium, and large size, Demirguc-Kunt, et al (2004) assessed the effect of banking market structure on access of firms to bank finance. They found that bank concentration increases obstacles to obtaining finance, but only in countries with low levels of economic and institutional development. They noted that the effect is exacerbated by more restrictions on banks' activities, more government interference in the banking sector, and a larger share of government-owned banks.