financial stability report - Banka Qendrore e Republikës së Kosovës

Financial Stability Report
Number 3
8. The Relationship between Banking Sector Competition and
Loan-Loss Provisions
Arben Mustafa* 17
Abstract
This article investigates the relationship between competition and risk-taking in the
banking sectors of Central and Eastern Europe transition economies, using bank level data
for the period 2002-2009. The measure of competition is estimated using the Panzar-Rosse
model, whereas the level of risk is proxied by loan-loss provisions. The results suggest that
banks operating in more competitive markets tend to take lower level of risks. The model
controls also for the impact of other bank-level and country-level indicators on the loan-loss
provisions.
8.1. Introduction
The issue of the risk taking behaviour of banks is deemed as very important both in the
literature and among the regulators primarily because the potential bankruptcy of banks is
considered to be associated with much larger negative consequences for the economy
compared to the bankruptcy of other types of firms. According to Beck et al. (2010) banks
differ from other types of firms because of three main reasons: a) potential bankruptcy of
banks entails high social costs, which are mainly related to potential losses for the
uninformed depositors who are not able to properly assess the risks they face; b) the
bankruptcy of a bank can negatively affect also other banks through the contagion effect 18 ,
thus affecting negatively the overall financial stability and the payments system; and c)
banks are special firms because of the presence of banking regulation, which implies also
the existence of a safety net for banks that, among others, includes deposits insurance,
lender of last resort and a procedure for the resolution of banking crisis. The existence of
such a safety net may impose a considerable financial burden for the regulator and the
government, thus increasing the overall cost of a bank’s bankruptcy.
Acknowledging the potential costs associated with bank risks, the economic literature has
largely dealt with factors that lead banks to take higher risks. In this context, considerable
attention has been paid to the relationship between competition and the risk-taking
behaviour of banks with a significant part of the literature arguing that competition has a
significant impact on the level of risk taken by banks. However, the literature so far has not
reached a consensus on the type of impact that competition has on risk-taking behaviour.
The prevailing view holds that banks operating in more competitive markets take higher
levels of risk. Based on this view regulators, especially in the past, have often undertaken
*Arben Mustafa is Director of the Financial Stability and Economic Analysis Department at the Central Bank of the Republic of Kosovo. Views expressed in this
article are the Authors’ and do not necessarily express the official views of the Central Bank of the Republic of Kosovo.
18 Contagion effect can occur in two forms: (i) the bankruptcy of a bank increases the uncertainty of other banks’ clients regarding the immunity of their own
banks and may induce them to withdraw their deposits; (ii) because banks hold claims on other banks, the bankruptcy of one of the banks may cause losses
also to other connected banks.
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