Competition and Financial Stability in European Cooperative Banks

Abstract

Cooperative banks are a driving force for socially committed business at a local level accounting for around one fifth of the European Union (EU) bank deposits and loans. Despite their importance, little is known about the relationship between bank stability and competition for these small credit institutions. Does competition affect the stability of cooperative banks? Does banks’ financial stability increase/decrease in case of higher competition? We assess the dynamic relationship between competition and bank soundness (both in the short and long run) in the European cooperative banking between 1998 and 2009. We obtain three main results. First, we support the competition-stability view proposed by Boyd and De Nicolo (2005). Bank market power negatively Granger-cause banks’ soundness meaning that there is a positive relationship between competition and stability. Second, we provide evidence of the negative impact of the 2007-2009 financial crisis on the individual risk exposure of cooperative banks although it does not change the relationship between competition and stability. Third, we show that herding behavior affects positively bank soundness. Our findings have important policy implications for designing and implementing regulations that enhance the overall stability of the financial system.