REVISITING THE IMPACT OF COMPETITION ON INDIVIDUAL AND SYSTEMIC BANKING STABILITY: EVIDENCE FROM DUAL BANKING SYSTEM

Abstract

In this paper, we analysed the effect of bank competition on individual bank stability (micro level) and systemic stability (macro level). On the micro level, our result presents that by controlling capital adequacy, there is a U-shaped relationship between competition and bank stability, thus highlighting the dual importance of the franchise value and the risk-shifting paradigms in dual banking systems. The comparative analysis of IBs and CBs revealed that the fragility effect is more pronounced for IBs than for CBs, indicating competition has a more considerable detrimental impact on the stability of IBs. Importantly, our analysis revealed that better bank capitalization has a moderating effect on the relationship between competition and bank stability in dual banking systems. This result is paramount as it underlines the dual importance of competition policy and capital regulation and the need to coordinate between these two pillars of regulation to foster the banking system's stability. Moreover, this moderating effect applies to IBs and CBs and does not differ. In a nutshell, our study points out that focusing on capital requirements without looking at competition policy will lead to suboptimal regulation. On the macro level, the evidence shows that higher competition tends to reduce systemic risk exposure, with no differential impact between IBs and CBs. However, our results reveal a non-linear relationship between competition and systemic risk. Specifically, greater competition increases systemic stability, but higher competition exacerbates banks' systemic risk beyond a certain threshold. Additionally, larger banks are more vulnerable to systemic risk, and the lack of competition worsens this vulnerability. Moreover, competition did not impact systemic risk in the pre-crisis period. However, banks with greater market power in the post-crisis exhibited increased exposure to systemic risk, in which banks became more concentrated, complex, and interconnected internationally in the emerging market. Finally, the finding indicates that the macro-prudential policy alters the landscape of systemic stability, wherein systemic risk is higher in countries with lower activity restrictions, stricter capital stringency, weaker supervisory power, and higher diversification.