How Does Bank Competition Affect Banking Stability? The Case of an Emerging Market

Moath Ghaleb Al-Azzam,Ghada Tayem

doi:10.5539/ijbm.v17n3p62

Abstract

This paper examines the role of interbank competition on banking stability in Jordan, an emerging market. Using competition estimates measured by Lerner index, the paper examines the impact of competition on two important dimensions of banking stability, namely, credit risk and liquidity risk. The empirical results suggest that the effect of banking competition on stability differs according to the dimension of stability. After controlling for bank-level control variables and macroeconomic conditions, the empirical results of the impact of market power measured by Lerner index on credit risk show that an increase in price competition leads to more risk taking from banks. On the other hand, the impact of price competition on the second dimension of banking stability (liquidity risk) implies that an increase in price competition improves the liquidity position of banks. However, these results hold only for the sample of non-Islamic banks. Islamic banks may face wider mismatch between its assets and liabilities due to its inability to use conventional debt instruments offered by the market and hence it keeps larger cash buffers to compensate for this extra risk.

Highlights

The question whether there is a relationship between competition and stability in the banking system and the direction of this relationship is important especially that the prevailing view is that competition worsens stability (Keeley, 1990; Allen & Gale, 2004)
As mentioned before we firstly estimated the first derivative of the translog cost function that specified in equation (4) using the fixed effect estimator to computing the marginal cost (MC)
This paper examines the impact of competition measured by Lerner Index on two dimensions of financial stability: credit risk and liquidity risk

Summary

Introduction

The question whether there is a relationship between competition and stability in the banking system and the direction of this relationship is important especially that the prevailing view is that competition worsens stability (Keeley, 1990; Allen & Gale, 2004). There has been a renewed interest in understanding this relationship from both an academic and policy making point of views after the recent financial crisis of 2008. This interest extends beyond large economies, such as the US, into more developing and less developing economies. This paper contributes to the literature of the influence of bank competition on the incentives of banks to take more (alternatively less) risky actions using the context of Jordan Understanding this trade-off provides policy makers with the knowledge needed to design and organize an efficient and sound banking system that is able to support sustainable economic growth

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