Competition and risk-taking in European banking

Transcription

1 Competition and risk-taking in European banking Jens Forssbæck a* and Choudhry Tanveer Shehzad b a Lund University, School of Economics and Management, PO Box 7080, Lund, Sweden b University of Groningen, Faculty of Economics and Business, PO Box 800, 9700 AV, Groningen, The Netherlands PRELIMINARY DRAFT! First version: May 6, 2011 This version: May 6, 2011 Abstract The paper tests the effect of banking-sector competition on bank risk-taking for a sample of about 400 European banks over the period Following the theoretical literature on bank competition and risk more closely than previous empirical research, we measure competition at the bank level and separate the effects of competition in deposit and loan markets. We also condition the effect of competition on several factors, including proxies of charter value and deposit insurance coverage. Our results give a relatively clear indication of a positive competition-risk effect for 3 of 4 risk measures tested. There is some indication, however, that this effect is strongly dependent on the existence of a deposit insurance-related moral hazard effect on risk, which is mitigated by increased market power. The frequently significant non-monotonicity of the competition-risk effect, and its potentially strong dependence on safety-net characteristics could possibly explain the conflicting results of previous empirical research. Key words: bank risk; competition; market power; financial stability; bank market structure JEL: G21; G28; D40; F39 * Corresponding author. Tel.: ; jens.forssbaeck@fek.lu.se

2 1. Introduction The determinants of bank risk-taking have been the objects of considerable research efforts within the banking literature. Beside the moral hazard effects of publicly sponsored safety nets (such as deposit insurance), a key factor to which research points is the effect of competition in the banking sector. But while the risk effects of deposit insurance are relatively well-documented (see, e.g., Demirgüç-Kunt and Detragiache, 2002, and Hovakimian et al., 2003), the effects of banking-sector competition on bank risk and overall financial system fragility remain despite a relatively large body of literature theoretically ambiguous and empirically under-investigated, especially in terms of cross-country evidence. The traditional view holds that as competition increases, banks have increased incentives to take on more risk an effect that can be explained by what is sometimes called the charter value hypothesis : banks in less competitive banking systems have more market power and can extract monopoly rents from valuable bank charters; this makes them less prone to take excessive risks, since higher risk implies jeopardizing future rents (see, e.g., Keeley, 1990). Contrary to this view, a more recent literature suggests a negative effect of banking-sector competition on risk, based on the analysis of both deposit market and loan market competition simultaneously (Boyd and De Nicoló, 2005; Boyd et al., 2009), or on endogenizing market power dynamically (Perotti and Suarez, 2002). A number of contributions, finally, predict a non-monotonic effect of competition on bank risk-taking, for instance by allowing for the existence of bankruptcy costs (Boyd and De Nicoló, 2003), or imperfectly correlated loan defaults (Martinez-Miera and Repullo, 2008). The empirical literature mirrors the conflicting results of theory. Early evidence on US data tends to favor the charter value hypothesis (Marcus, 1984; Keeley, 1990), whereas 2

3 more recent cross-country evidence points in different directions. For instance, De Nicoló et al. (2004) and Boyd et al. (2009) find a positive association between concentration in the banking sector and banks overall default risk, thus suggesting that more competition should be associated with more stable banks. Similarly, Beck et al. (2006) find that countries with higher regulatory entry barriers to the banking sector run a significantly higher risk of suffering a systemic financial crisis, but they also find that higher concentration in the banking sector is associated with a lower probability of crisis. The results of Berger et al. (2009), finally, provide support for the hypothesis of a non-monotonic effect of competition on bank risk, but whether the positive or negative effect dominates depends on the risk measure used. (They find a primarily negative effect of competition on banks asset risk, whereas the effect of increased competition on overall default risk is primarily positive.) Several factors complicate both interpretation of existing empirical evidence as tests of theory, and comparability between the different existing studies. First, the bulk of the theoretical literature refers to the risk-taking effects of competition in the deposit market, whereas the results of, e.g., Boyd and De Nicoló (2005) and Martinez-Miera and Repullo (2008) suggest that the effects of competition in the loan market may differ. In the empirical literature, separation between loan and deposit market competition has only been made to a very limited extent. Moreover, the market concentration measures typically used in the empirical literature to gauge competition (usually the Hirschman-Herfindahl Index, HHI, or the market share of the n largest banks) may not be adequate indicators of competition for several reasons (including the fact that they presume that market concentration affects the competitive behavior of all banks within a country in the same way, and that they take into account neither the threat of entry nor the intensity of competition between the leading banks; see, e.g., Claessens and Laeven, 2004). 3

4 Second, results may diverge depending on whether they refer to the competition effects on banks asset risk or overall default risk. Much of the theory abstracts from the existence of equity, which makes the distinction between asset risk and default risk trivial, but the differing effects on asset risk and default risk found by Berger et al. (2009) suggest that the distinction may not be trivial in practice. They argue that banks compensate for higher asset risk by holding more capital, which pushes down default risk, but their results on the effect of competition on bank capital are mixed, and they do not directly condition the risk effects of competition on capitalization. Third, a substantial portion of the theoretical literature explicitly or implicitly relies on the existence of (underpriced) deposit insurance for the risk effects of competition to occur: essentially, the result is that the existence of monopoly rents mitigates the risk-taking incentives created by deposit insurance, but without deposit insurance there is no risk incentive in the first place, and therefore no variation in risk due to competition. This suggests that deposit insurance should be taken into account when empirically testing for the risk effects of competition, but to our knowledge, this has never been done. Fourth, what the charter value hypothesis really suggests is that increased competition raises banks risk-taking conditional on the pre-existence of a charter value to protect, i.e., conditional on the initial degree of market power (whereas the effect of increasing competition further if it is already relatively high is unclear). This argument suggests a possible non-linear relation, which is in line with some of the more recent theoretical contributions (e.g., Martinez-Miera and Repullo, 2008). It could explain the diverging results of existing empirical studies testing a linear relationship, and suggests that the effect of competition on risk should be tested non-linearly (or possibly be conditioned on a proxy of charter value). To our knowledge, only one study so far (Berger et al., 2009) has allowed for a non-constant effect when testing the competition-risk relation empirically. 4

5 The purpose of the present paper is to empirically test the relationship between competition and bank risk-taking in a series of panel regressions using cross-country banklevel data, and to do it in such a way that the econometric specifications explicitly take into account the theoretical complexities of the issue, and so as to disentangle some of the potentially conflicting effects identified above. To this end, we employ Bankscope data covering a maximum of 419 banks in 35 European countries over the period (a sub-sample of a larger dataset covering a total of approximately 2000 banks in 76 countries worldwide). The main contributions of the study are as follows. First, we measure competition directly at the bank level, and differentiate between deposit and loan market competition by calculating separate Lerner indices for each market and bank. In so doing, we do not impose the same competition effects of market structure on all banks, and we avoid the problems with using concentration as a measure of competition. 1 Second, bank risk-taking is measured in several different ways. We use four different risk proxies as dependent variables: a proxy of asset risk/quality (the ratio of impaired loans to gross loans), two proxies of overall default risk (the conventional Z-score and a simplified version of a Merton-type distance to default), and a simple market-based risk measure (the volatility of stock returns). Third, in line with most of the available theory, we explicitly condition the risk effects of increased competition on several factors. These include a quadratic term of the competition measures used (in order to reflect a possible non-monotonic relationship between competition and risk), the capital ratios and the market-to-book values of the included banks (to account 1 The Lerner index has been used before to test the risk effects of competition, but not separately for the deposit and loan markets. Berger et al. (2009) differentiate between deposit and loan market competition by calculating HHI for each market, but their tests are cross-sectional and their sample contains only 23 countries, which gives rise to limited variation in their main independent variable (and HHI/market concentration is still subject to the criticism noted above). 5

6 for the possible asset risk/leverage tradeoff, and to explicitly test the charter value hypothesis), and different proxies of deposit insurance coverage (to reflect the fact that a large portion of the theoretical literature relies on deposit-insurance-related moral hazard for the risk effect of competition to occur). The results suggest a basic support of the traditional competition-fragility view, where the higher monopoly pricing power associated with less competition mitigates the riskincentives stemming from deposit insurance. Increasing market power typically has a negative effect on bank risk-taking (except when risk is measured as the Z-score), and this negative risk effect usually dominates for both deposit and loan markets although the effect is frequently significantly non-linear, and is usually of comparable magnitude for both deposits and loans. In several specifications, however, the results suggest that this effect is more or less entirely conditional on the existence of deposit insurance: without deposit insurance (or if deposit insurance coverage is low) the effect of market power on risk is non-existent or even positive. The exact nature of this conditionality, however, varies somewhat depending on the risk measure used, and does not appear at all when risk is proxied by asset quality. We further find mixed evidence of the asset risk/leverage tradeoff, and none at all for a more explicit formulation of the charter value hypothesis, where the risk effect of competition is allowed to depend on a proxy of charter value (market/book value). Finally, we find that concentration usually has the opposite effect on risk as that of the Lerner indices (i.e. positive) and that the stand-alone effect of deposit insurance on risk is ambiguous. The remainder of this paper is organized as follows: Section 2 briefly summarizes existing theoretical as well as empirical results on the association between competition and bank risk-taking, Section 3 describes the data and the empirical methodology, Section 4 presents the results, and Section 5, finally, concludes. 6

7 2. Competition and bank risk-taking: theory and evidence The theoretical literature on the effects of competition in the banking sector on banks risk-taking is relatively extensive, but is as noted above partly contradictory. It basically points in two different directions: part of the literature predicts a risk-increasing effect of competition (this is the traditional view); a more recent part of the literature suggests instead that risk-taking decreases as a consequence of more competition. (Some recent contributions also imply a non-monotonic effect, as noted above.) The logic of the traditional view is that incumbent banks in less competitive banking systems, with relatively high entry barriers, have more market power and can extract monopoly rents from valuable bank charters. This makes them less prone to exploit risk-shifting incentives, since increasing default risk would imply jeopardizing future rents. Increased competition decreases profits and thereby charter values, thus making risk-shifting relatively more attractive (the charter value hypothesis ). It is notable that a large portion of this part of the literature explicitly or implicitly links the risk effects of competition to the risk-shifting incentives of deposit insurance. Such is the case in the early contributions of Marcus (1984) and Keeley (1990), as well as in the later contributions of Matutes and Vives (1996) and Allen and Gale (2000, 2004), all in which the moral hazard effect of deposit insurance is counteracted by limited competition, and the risk effects of competition stem from giving freer play to these moral hazard effects. Similarly, in Boyd and De Nicoló (2005), if deposit insurance is fairly priced, it breaks down the relation between competition and risk; along the same lines, disclosure of bank risk or market discipline by depositors can have a similar effect as eliminating (or correctly pricing) deposit insurance (Cordella and Levy Yeyati, 2002). A similar line of reasoning as the charter value hypothesis underpins the argument that more concentrated and less competitive banking systems are less prone to systemic banking crises, because the higher profits implied by limited competition and higher market power 7

8 provide a buffer against adverse shocks, thereby reducing systemic risk (see, for instance, Matutes and Vives, 2000). Although other mechanisms have been suggested (for example, Allen and Gale, 2000, argue that more concentrated banking systems are more easily and effectively monitored by financial supervisory authorities than diffuse systems), a key implication of the competition fragility view is that banks should have relatively high profits and high valuations. Any risk effect of increased competition takes its way via profit margins and relative valuations. The basic driver is thus the mechanism that as profits decrease, risk-taking increases. Boyd and De Nicoló (2005) show that the assumption that banks directly control the riskiness of their asset portfolio may be crucial for this mechanism to occur. They argue that the traditional view is largely a result of focusing on deposit market competition while treating the asset side of banks balance sheets as a portfolio problem with exogenously given return distributions. Instead of the portfolio approach, Boyd and De Nicoló (2005) advocate an optimal contracting approach, which allows for competition both in the loan and deposit markets. They analyze a setting where banks lend to entrepreneurs, who in turn invest in risky projects. Like banks, entrepreneurs have higher incentives to take risks when profitability decreases, but greater competition in the loan market depresses lending rates, increasing entrepreneurs profits and decreasing their risk-taking incentives, and with them the risk of banks asset portfolios. The positive effect on bank risk of deposit market competition remains, but the negative effect of loan market competition dominates. A negative risk effect of competition can also be accommodated by the last bank standing story of Perotti and Suarez (2002). They analyze the incentives for speculative lending in a dynamic setting where market concentration is endogenized. The main effect is that banks have an incentive to lend prudently if their competitors take on more risks, since the increased probability that competitors will fail increases expectations of higher 8

9 concentration and therefore of higher rents for surviving banks in the future. However, they also show that higher current market concentration may increase speculative lending. The mechanism is that expectations of lower future market concentration (via market entry) may create an incentive for banks to maximize the benefits of a temporarily higher market share through the short-term gains of speculative lending. Yet another view again building on the moral hazard effects of public guarantees to banks holds that in more highly concentrated banking systems, with a small number of relatively large and systemically important banks, implicit guarantees associated with toobig-to-fail policies are more likely. This induces (the large) banks to take on higher risks, in the expectation of being bailed out in case of default (see, for instance, Boyd and Runkle, 1993; Mishkin, 1999). This line of reasoning suggests that banks in more concentrated (less competitive) markets should be more risky. Thus, theory predicts either a positive or a negative of competition on bank risk-taking. To complicate things even further, a number of recent contributions imply a non-monotonic effect. Martinez-Miera and Repullo (2008) is one of few papers studying loan market competition in isolation. Using the same setup as Boyd and De Nicoló (2005), they suggest that the results of the latter crucially hinge on the assumption of perfectly correlated loan defaults, and dropping this assumption produce results that imply a U-shaped relationship between competition and bank risk. A similar non-monotonic effect is actually explicitly or implicitly present in several contributions. The results of Perotti and Suarez (2002) suggest that the effect of competition depends on current and/or expected future competition, and in Boyd and De Nicoló (2003), the existence of bankruptcy costs gives rise to a non-monotonic effect. More generally, it could be argued that the charter value hypothesis relies not only on the existence of deposit-insurance-induced moral hazard, but also on the pre-existence of non-trivial charter values; if none such exists (if competition is already relatively intensive), 9

10 the charter value hypothesis has little to say about the effects of increasing competition further. The theoretical ambiguity with respect to the effects of competition on bank risk-taking is mirrored by the empirical evidence. Early evidence on US data (Marcus, 1984; Keeley, 1990) typically proxy competition by relative valuations (Tobin s Q), reflecting the view that banks operating in less competitive markets should be more highly valued, and find some indication of a positive association between competition and risk. More recent results on both US and international data are more mixed. For example, De Nicoló et al. (2004) test joint risk-taking by the largest 5 banks in an economy against banking-sector concentration, using data for several hundred banks worldwide in the years 1995 and The findings suggest a positive association between concentration and bank risk-taking, thus contradicting the traditional hypothesis that higher market power should be associated with lower risk. Similarly, Boyd et al. (2009) test the effects of banking sector concentration (measured by the HHI) on banks default risk, using both a US dataset and an international dataset of developing countries (each dataset containing more than 2000 banks). In line with De Nicoló et al. (2004), the results seem to refute the competition-instability view for both datasets in that the estimated effect of concentration on risk is positive (although as noted by Berger et al., 2009 while statistically significant, the results suggest an effect that is economically negligible). Also using country-level proxies of competition, but measuring the effect of overall financial stability measured as the probability of a systemic crisis (rather than measuring individual bank risk), Beck et al. (2006) again find contradictory results. On the one hand, higher banking market concentration is associated with lower probability of a systemic crisis, but on the other hand, higher (regulatory) entry barriers to the banking sector increase this probability. 10

11 Berger et al. (2009), finally, use both country-wide concentration measures (HHI) and an overall Lerner index for individual banks (but they only distinguish between deposit and loan market competition for the HH indices) for a larger sample of banks from 23 developed countries. They find a significantly non-monotonic relationship between competition (measured as either of these proxies) and bank risk-taking, but whether the positive or negative effect dominates depends on the risk proxy used: increased competition has a primarily negative effect on asset risk, whereas the effect on overall default risk is predominantly positive. Berger et al. (2009) argue that these different effects may not be irreconcilable (and that their own results, in turn, do not necessarily contradict the diverging results of previous studies) if banks compensate for the increased asset risk due to higher competition by other risk management techniques, e.g., by holding more capital (suggesting an asset risk/leverage tradeoff along the lines of that documented by Forssbæck, 2011). But the fact is that the empirical literature does yield opposing results: both asset risk and default risk can either rise or fall with increased competition, depending on the study. More than just the risk measure used, the contradictions may depend among other things, if the theoretical literature is anything of a guide on whether the deposit or loan market (or both) is studied, and on whether the existence of deposit insurance and a host of other factors are taken into account (and possibly allowed to explicitly condition the effects of competition). Moreover, the possibility of a non-monotonic effect suggests that the estimated effect of competition depends on the degree of variation in the competition measure used (which is a further argument against using market-wide concentration measures to proxy competition). In this paper we address several of these issues. The next section describes our methodology. 11

12 3. Data and methodology 3.1. Empirical specifications and estimations The empirical method is panel-data regressions of the following general specification (where subscripts i, j and t denote bank, country and time period): Risk = β + β (Competition) + β (Competition) 2 it 0 1 it 2 it + β (Competition) (Conditioning variable) m 3 it p + β (Bank-level control) + β (Country-level control) + ε 3+ k mit 3+ m+ n njt it k= 1 n= 1 ijt. (1) The regressions are estimated with fixed effects in all cases. To avoid possible endogeneity problems, all independent variables are lagged one period. Competition is measured as the Lerner index calculated for deposits and loans separately (the Lerner index measures relative price margins above marginal cost for a firm s output; it is therefore a measure of monopoly pricing power, or market power, and is thus inversely related to competition). In calculating Lerner indices for deposits and loans, we essentially follow Koetter et al. (forthcoming), by first estimating a translog cost function of the following form: J T S 3 2 ln( C ) = α + α + α + β ln( W ) + γ ln( Y ) + δ ln( E ) it 1 j 2t 3s h hit k kit it j= 1 t= 1 s= 1 h= 1 k= ( ) + 0.5φ ln( W )ln( W ) + 0.5η ln( Y ) + 0.5κ ln( Y )ln( Y ) hm hit mit k kit 1it 2it h= 1 m= 1 k = n λ hk ln( Whit )ln( Ykit ) µ nt π h ln( Whit ) T + θk ln( Ykit ) T + ς p X pjt + uit h= 1 k = 1 n= 1 h= 1 k= 1 p= (2) which specifies total costs (C) as a function of three input prices W h (the price of borrowed funds, the price of labor, and the price of fixed capital), two outputs Y k (loans and deposits), total equity E, a time trend representing technical change (T), a set of country-level control variables X p (GDP per capita, GDP growth, inflation, and population density), and country, time, and bank specialization dummy variables (α 1 α 3 ). Marginal costs for loans (mc 1 ) and deposits (mc 2 ) are then given by: 12

13 3 mc1 it = Cit / Y1 it = γ1 + η1 ln( Y1 it ) + 0.5κ ln( Y2 it ) + λh1 ln( Whit ) + θ1t Cit / Y1 it, and h= 1 3 mc = C / Y = γ + η ln( Y ) + 0.5κ ln( Y ) + λ ln( W ) + θ T C / Y 2it it 2it 2 2 2it 1it h2 hit 2 it 2it h= 1 (3) Finally, Lerner indices for loans (LL) and deposits (LD) are calculated as (see, e.g., Maudos and Guevara, 2007): LL = ( r r mc ) / r it Lit jt 1it Lit LD = ( r r mc ) / r it jt Dit 2it Dit (4) where r Lit and r Dit are the lending and deposit rates, respectively, set by bank i at time t, and r jt is the money market rate in country j at time t Data and variable definitions The main data type used is annual financial-statement data for the sample banks over the period , all from Bankscope. In addition, we use bank-level stock-market data and country-level data on banking-sector concentration, banking regulation, and macroeconomic control variables, with definitions and sources as specified below. Risk measures We use four different risk proxies as dependent variables in the main regressions. The first is the ratio of impaired loans over gross loans, as indicated in the Bankscope data. This is essentially a proxy of asset risk, or asset quality. The second is a simplified version of a Merton-type distance to default (DD), which measures overall default risk. It is defined as: Modified DD it ln( Lit ) = ( L 1) σ it E, it where the leverage ratio L is calculated as the book value of total liabilities divided by the sum of total liabilities and the market value of equity, and σ E is the annualized standard 13

14 deviation of monthly stock returns. The stock market variables going into the calculation of the modified DD were taken from Datastream. An alternative measure of default risk commonly used in the banking literature is the Z-score, defined as: ROAit + ( E / TA) it Z-score it = σ ROA, i where the return on assets (ROA) and the capitalization ratio (equity capital over total assets, E/TA) are observed annually, and the standard deviation of ROA (σ ROA ) is calculated over the entire sample period. Finally, we use stock return volatility σ E (as defined above) as a simple market-based risk proxy. Cost function and Lerner indices The bank-level data used to estimate the cost function (2) are all financial-statement data from Bankscope, with definitions as follows (definitions follow Koetter et al., forthcoming, and Maudos and Guevara, 2007, closely). Total costs are defined as the cost/income ratio multiplied by total income. The input prices the cost of borrowed funds, labor costs, and the cost of fixed capital are defined as, respectively, total interest expenses over total liabilities, personnel expenses over total assets, and other operating expenses over fixed assets. The proxy of loans is total earning assets, and that of deposits is the sum of total deposits and short-term funding. Finally, the lending and deposit rates used to calculate the Lerner indices (4) were calculated as the sum of interest income on loans, other interest income and other income, divided by total earning assets (lending rate), and total interest expenses divided by the sum of deposits and short-term funding (deposit rate). All countrylevel macroeconomic variables used to estimate the cost function were taken from IFS, which also goes for the money market interest rates used to calculate Lerner indices. 14

15 Other independent variables In the final regressions, bank-level control variables include the ratio of fixed assets to total assets, equity capital over total assets (the capitalization ratio), and the cost/income ratio all from Bankscope. We also use the market-to-book ratio for each bank and year as a proxy of charter value, which are price-to-book values from Datastream. At the country level, we control for bank market concentration as defined in the World Bank s Financial Structure Database. It is calculated as the total assets of the three largest banks divided by the total assets of all commercial banks. We further use two proxies to account for the existence and the strength of deposit insurance in each of the sample countries both constructed using information from the World Bank s Banking Regulation Surveys from 2001, 2005, and The first proxy is a simple dummy variable indicating if there is a formal deposit insurance system. The second is an index variable indicating deposit insurance strength, which takes on zero value if there is no formal deposit insurance system, or else integer values between 1 and 3, depending on the level of protection offered by the insurance (based on answers to three yes/no survey questions, where higher value indicates more protection. The deposit insurance indicators are constant over time in-between surveys [indicators for ?]. Summary statistics Descriptive statistics appear in Table 1, and correlations between the variables used in Table 2. Note that these summary statistics refer to the full (global) sample, not just the European banks, which explains the large number of observations for most variables. One thing that significantly reduces the number of observations in the final regressions is the simultaneous inclusion of Lerner indices for both deposits and loans, as data limitations on the input variables for loan market Lerner indices reduces the number of observations for this variable in comparison to all other variables. 15

16 Pairwise correlations between the variables do not indicate any multicollinearity problems. As for correlations between the various risk measures employed, correlations are mostly around 30 percent or less, suggesting that they may indeed measure different dimensions of the banks risk taking. The one exception is the correlation between the modified distance to default and stock return volatility, which amounts to negative 62 percent (which makes sense since stock return volatility enters into the calculation of the modified distance to default). Regarding the competition proxies used, the simple correlations to some extent illustrate our point that the effects of loans and deposit market competition may differ (Lerner indices for loan and deposit markets are negatively correlated), and that simple concentration measures may not adequately capture competition effects (bank market concentration is correlated positively with loan market power and negatively with deposit market power). Finally, it is notable that the deposit insurance dummy and the index of deposit insurance strength are relatively modestly correlated at 34 percent. 4. Results Our preliminary regression results for the European banks in our sample appear in Tables 3-6. When the impaired loans to gross loans ratio is used as risk measure (Table 3 and Figure 1A), the results indicate a predominantly negative effect of market power for both deposits and loans on asset quality (or, equivalently, increased competition is associated with higher risk). The effect of the deposit market Lerner index tends toward convexity (except for specification III), but the effect is relatively modest: a one standard deviation increase in the Lerner index corresponds to a reduction in the impaired loans ratio of about one percentage point on average, and the curve bottoms out at about one standard deviation above the mean. The risk effect of loan market power is greater, and significantly concave but negative for the 16

17 entire sample distribution. Raising the loan market Lerner index by one standard deviation from the mean decreases the impaired loans ratio by about four percentage points on average. The effects of the conditioning variables are small and insignificant with one exception: in specification III, a higher market/book ratio reduces the negative risk effect of loan market power, which somewhat contradicts the charter value hypothesis (but the effect is relatively small and only marginally significant). Bank market concentration is significantly positively associated with risk when measured as the impaired loans ratio, which is largely in line with previous literature (e.g. Berger et al., 2009, find a predominantly positive effect of concentration on the nonperforming loans ratio), but also in the perspective of the results for the Lerner indices again illustrates the potentially misleading conclusions of using concentration measures as proxies of competition. Among our other main variables of interest we expect that the deposit insurance variables should be positively related to risk. This is only partially confirmed: the deposit insurance dummy is mostly positive, but only (marginally) significant in two of the four specifications. Coefficients for deposit insurance strength are typically significantly negative, but indicate small effects. As expected, capitalization is usually negatively associated with asset risk, but never significantly so. When the modified distance to default is used as risk measure (Table 4), the picture becomes a bit more varied. Coefficients for the Lerner indices change signs across specifications, there is no significant non-linearity, but a couple of the interaction terms suggest that strong conditioning effects are present. Specifications II-IV indicate a relatively unambiguous overall positive effect of deposit market power on the distance to default. Again, this has the equivalent interpretation of a positive competition-risk association. Exemplifying with specification II (Figure 1B), the effect is close to linear and on the order of a 10 unit change in distance-to-default standard deviations per one standard deviation 17

18 change in the Lerner index (note that the sample standard deviation for the modified distance to default is [check this!]). Specification I suggests that this positive effect of deposit market power is strongly dependent on the existence of deposit insurance, and that for bank/year observations without deposit insurance, the overall effect is instead negative. However, instead interacting the deposit market Lerner index with the alternative indicator deposit insurance strength gives no hint of this conditionality, which casts some doubt on the robustness of this finding. Nonetheless, the same pattern recurs for the loan market Lerner index, whose overall effects are very similar as that of deposit market power (with the exception of specification III, which indicates an insignificantly negative overall effect). For both deposit and loans market power, the interaction term with capitalization is negative and significant (though rather small), suggesting that the risk effect of increasing competition is somewhat smaller for better capitalized banks. For the modified distance to default, the stand-alone effects of both concentration and capitalization are never significant. The individual effects of the deposit insurance proxies are again partly contrary to expectation in that the deposit insurance dummy is consistently (and in two out of four specifications significantly) associated with a higher distance to default (i.e. lower risk). Since the Z-score can be interpreted as a sort of simplified distance to default, we expected that the results should be comparable with those for the modified distance to default. This is not the case, however: the Z-score is the only risk measure which suggests a negative overall association between risk and competition. Again, however, the estimated effects vary considerably across specifications (see Table 5). Exemplifying with specification I (Figure 1C), the effect of the deposit Lerner index is predominantly negative, but convex with the minimum occurring about half a standard deviation above the mean. The magnitude 18

19 of the effect is on the order of a 5 unit decrease in the Z-score (global sample mean 10, standard deviation 12) per standard deviation increase in the deposit Lerner index. As for the loan market Lerner index, it also usually has a negative overall effect on the Z-score, but the effects here vary a great deal across specifications, and neither the linear nor the quadratic terms are significant in any specification. Again, the smaller sample in specification III deviates from the general pattern for both Lerner indices (to the extent that any pattern can be detected for loan market power). Specifications I and II both indicate that the negative overall effects of market power may be conditioned by deposit insurance, such that the existence of (stronger) deposit insurance may turn the effect positive. This is more or less the case with both loan and deposit market Lerner indices. This effect recalls the strong conditionality of the risk-reducing effect of market power on the deposit insurance dummy found for the modified distance to default, and lends further support to our argument that the traditional competition-instability view relies on the existence of deposit insurance. When interacting the market power proxies with market/book value and the capitalization ratio, coefficients turn out insignificant in all cases. As for the stand-alone effects of other variables of interest, concentration is usually significantly negatively associated with the Z-score, indicating a positive concentration-risk relationship (cf. results for the impaired loans ratio). The deposit insurance proxies, on the other hand, are insignificant in all cases but one: specification II indicates a (weakly) significant effect of deposit insurance strength with the expected negative sign. A somewhat unexpected result of the Z-score regressions is the relatively large and consistently significant negative effect of the capitalization ratio. This suggests that better capitalized banks have higher default risk as measured by the Z-score, which seems a bit counterintuitive. The size of the effect is 19

20 approximately such that a one standard deviation increase in the capitalization ratio corresponds to a one standard deviation decrease in the Z-score. The results for stock return volatility, finally, again typically indicate a convex negative effect of deposit market power and a concave negative effect of loan market power on bank risk (Table 6, Figure 1D). However, the quadratic term for the deposit Lerner index is never significant. For both deposits and loans, the size of the effect is approximately on the order of a 5 percent point decrease in stock return volatility per standard deviation increase in the Lerner index (where 5 percent corresponds to about 5/7 of a standard deviation in volatility based on the global sample summary statistics). However, specification I suggests that the effect is considerably stronger in the presence of deposit insurance: the interaction terms between the deposit insurance dummy and both Lerner indices are highly significant and negative. Instead interacting with the index of deposit insurance strength yields insignificant (deposits) or weakly positive (loans) coefficient estimates. Nonetheless, the stock return volatility regressions well mirror the results for the Z-score and, especially, the modified distance to default regressions, suggesting that the risk-reducing effects of market power is greater in the presence of deposit insurance. Also significant (but quite small) are the effects of the interaction terms between Lerner indices and capitalization (specification IV). The sign of the coefficient estimates suggests that better capitalized banks risk is less sensitive to changes in competition, which is in line with the results obtained in the corresponding specification for the modified distance to default reported in Table 4. As for the individual effect of deposit insurance (strength), it is also negative (which, again, is unexpected because it contradicts the moral hazard effects of deposit insurance) or insignificant. When risk is measured as stock return volatility there is no significant effect of 20

21 bank market concentration. Individual coefficient estimates for the capitalization ratio, finally, are significantly negative (as expected) or insignificant. 5. Conclusions Despite considerable research efforts, the effects of banking sector competition on banks risk taking behavior remains theoretically ambiguous and empirically contradictory. On the one hand, the traditional competition-fragility view holds that as competition increases, banks become more risk-prone. This mechanism is often motivated by the charter value hypothesis : banks in less competitive banking systems earn monopoly rents from valuable bank charters, which makes them less inclined to exploit risk-shifting incentives in order not to jeopardize future rents (a sort of quiet life hypothesis applied to risk behavior). Contrary to this view is the competition-stability view, which can be motivated on several grounds. In particular, the higher lending rates charged by a monopolist bank transfers a riskshifting incentive to the loan-taker, which may increase the riskiness of the bank s asset portfolio. In addition, it has been argued that banks in less competitive, more concentrated banking markets are more likely to benefit from implicit too-big-to-fail guarantees, which creates a moral hazard-related incentive for risk-taking. We argue that the existing empirical literature is difficult to interpret as direct tests of theory for several reasons. First, most of the theoretical research underpinning the competition-fragility view refers to the effects of competition in the deposit market, whereas the effect on banks asset risk of the borrowers risk-shifting incentives is an effect of competition in the loan market. This suggests that the risk effects of deposit market and loan market competition may differ. Second, previous research has indicated that the market- /country-wide concentration measures typically used in previous empirical literature on the risk effects of competition may not adequately capture competition. Similarly, risk effects of 21

22 competition may differ depending on the risk proxy used. Third, we argue that the charter value hypothesis suggests that the competition effects on risk are conditioned by the existence of deposit insurance, by a proxy of the charter value of the bank, and, possibly, by the bank s capitalization level. It may also be non-monotonic. We explicitly account for these various effects in a series of regressions on a large sample of banks over the period. Competition is measured at the bank level by calculating Lerner indices measuring market power separately for deposit and loan markets (while using the country-level bank market concentration as a control variable). We use four different risk measures as dependent variables: a proxy of asset risk/quality (the ratio of impaired loans to gross loans), two proxies of overall default risk (the conventional Z-score and a simplified version of a Merton-type distance to default), and a simple market-based risk measure (the volatility of stock returns). Moreover, we use two proxies to account for the effect of deposit insurance: a simple dummy variable indicating the existence of a formal deposit insurance system, and an index variable proxying deposit insurance strength. These are tested individually as well as in interaction with the Lerner indices of market power. In addition, we also allow for the possible conditionality of the risk effect of competition on a proxy of charter value (the market to book value) and on the banks capital ratios. Results for the European part of our dataset (comprising of a maximum of 419 banks) are as follows. First, the data lend little support for the argument that the risk effects of competition are different depending on whether one considers competition in the deposit or loan market. Although the sample correlation between deposit and loan market Lerner indices is negative, and although the estimated coefficients often switch signs across specification and the effects are frequently significantly non-monotonic, the overall effects on risk over the relevant portions of the Lerner index distributions are almost always of the same sign (and often of about the same magnitude). 22

23 This brings us to the second point: the effect of market power on risk is almost always predominantly negative, which basically lends support to the traditional competition-fragility view. This general result holds for all risk measures tested except for the Z-score, for which we find a predominantly positive risk effect of market power. However, our estimates indicate that this result is very sensitive to the exact specification. In particular, conditioning the effect on the strength of deposit insurance shows that going from weak to strong deposit insurance can easily turn the overall effect around. This illustrates our third main point: for three out of four risk proxies, the negative risk effect of market power is strongly dependent on the existence of deposit insurance (modified distance to default and stock return volatility) or on deposit insurance strength (Z-score). In all these cases, the effects are of such magnitude that they potentially drive the entire negative risk effect of market power and the remaining, unconditional effect is insignificant or even positive. Although this conditionality does not appear completely robust, we argue that the result gives relatively strong backing to our argument that the competition-fragility view relies on the pre-existence of a moral hazard-related risk incentive induced by deposit insurance. We also argued that the charter value hypothesis may suggest that the competition-risk effect depends on a proxy of charter value: the higher the charter value, the stronger the (negative) link between market power and risk. We find essentially no support for this at all. Our proxy of charter value (the market to book ratio) enters insignificantly in interaction with both Lerner indices in all cases except one (where the coefficient is only marginally significant and has the wrong sign). Interacting the market power proxies with the capitalization ratio to test a possible asset risk/leverage tradeoff yields mixed results. For this test to make complete sense, we should really see a positive market power-risk relationship, which is conditional on capitalization. We do not see such a relationship in our results. We 23

24 do, however, see a negative relationship between the Lerner indices and risk which is significantly reduced (i.e. made more positive) by capitalization when risk is measured as the modified distance to default or as stock return volatility. In other words, for these two risk proxies, capitalization conditions the risk effects of competition in the expected direction. A somewhat unexpected result is that the stand-alone effect of deposit insurance frequently switches sign or is insignificant, but when significant more often than not has a negative effect on risk. Finally it is notable that the effect of country-wide banking market concentration on risk is insignificant or significantly positive in about an equal number of instances, but never significantly negative. This result notwithstanding, the overall impression of our results is basic support of the traditional competition-fragility view, where the higher monopoly pricing power associated with less competition mitigates the riskincentives stemming from deposit insurance. 24

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