Competition and Credit Procyclicality in European Banking

Abstract

This paper empirically assesses the effects of competition in the financial sector on credit procyclicality by estimating both an interacted panel VAR (IPVAR) model using macroeconomic data and a single-equation model with bank-level European banking data. The findings of these two empirical approaches highlight that an exogenous deviation of actual GDP from potential GDP leads to greater credit fluctuation in economies where: (i) competition among banks and, (ii) competition from non-bank financial institutions or direct finance (proxied by the financial structure) are weak. According to the financial accelerator theory, if lower competition strengthens the cyclical behavior of financial intermediaries, it follows that these endogenous developments in credit markets work to amplify and propagate shocks to the macroeconomy (Bernanke et al., 1999). Furthermore, since credit booms are closely associated with future financial crises (Laeven and Valencia, 2012), our results can also be read as evidence that greater competition in the financial sphere reduces financial instability, which is in line with the competition-stability view denying the existence of a trade-off between competition and stability.