financial stability report - Banka Qendrore e Republikës së Kosovës
financial stability report - Banka Qendrore e Republikës së Kosovës
financial stability report - Banka Qendrore e Republikës së Kosovës
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Number 3<br />
Financial Stability Report<br />
measures to restrict banking competition, aiming at safeguarding the banking system<br />
<strong>stability</strong>. However, the other strand of the literature promotes the view that banking<br />
competition reduces the level of risk taken banks, suggesting that banks with market<br />
power undertake higher levels of risk compared to banks operating in more competitive<br />
markets.<br />
The disagreement on whether competition deteriorates or enhances the banking sector<br />
<strong>stability</strong> has been present both in the theoretical and empirical studies. Empirical studies<br />
that have investigated this relationship are characterized by differences especially in the<br />
measure used for competition, with some studies using the level of regulatory restrictions to<br />
competition, while others using measures such as market concentration indices, Panzar-<br />
Rosse H-statistic, or the Lerner Index. There are also differences with regard to the<br />
measure used to proxy the bank risk, which mostly consists of loan quality, but also<br />
indicators of bank capitalization and the bank’s probability of default.<br />
This article investigates the relationship between competition and bank risk-taking for a<br />
sample of 15 Central and Eastern Europe (CEE) transition economies, using individual<br />
bank data for the period 2002-2009. To measure banking sector competition, the Panzar-<br />
Rosse model is estimated for each country and each year, whereas the level of bank risk is<br />
proxied by loan-loss provisions.<br />
8.2. Theoretical background of the relationship between banking sector<br />
competition and risk-taking<br />
This section provides a review of the theories on the relationship between banking sector<br />
competition and the risk-taking behaviour of banks. The literature on this field is quite<br />
inconclusive with one stream of the literature claiming that competition has a positive<br />
impact on the risk-taking in the banking sector, and the other view claiming that<br />
competition has a negative impact on the risk-taking.<br />
The view that more intense competition leads to higher risk-taking by banks is mainly<br />
based on the ‘’franchise value’’ or ‘’charter value’’ hypothesis, derived from the work of<br />
Keeley (1990). The franchise value refers to the present value of future profits earned by<br />
the bank upon the continuation of its operations. According to Keeley (1990), the increase of<br />
competition reduces the franchise value and induces banks to undertake higher risks in<br />
order to maintain/increase their profits. The higher level of undertaken risk will then be<br />
reflected into a lower quality of the asset portfolio and a lower level of bank capitalization.<br />
The franchise value hypothesis is supported also by a number of other authors such as<br />
Hellman et al. (2000) and Repullo (2003) who have claimed that increased competition<br />
leads to higher risk-taking by banks. The focus of these studies is the competition between<br />
banks in the market for deposits, where they find that higher competition induces banks to<br />
offer higher deposit interest rates in order to attract higher levels of deposits. Under these<br />
conditions, banks will tend to favour the investments in riskier assets, which provide a<br />
higher return in the present period, while the lower franchise value implies a lower<br />
opportunity cost in terms of foregone future profits if the bank goes bankrupt.<br />
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However, the impact of competition on bank risk-taking depends on a number of other<br />
factors, such as the disclosure of risk information by banks, the presence of a deposit<br />
insurance scheme, and the regulatory capital requirements, which interact with<br />
competition in determining the risk-taking attitude of banks. In this context, if risk<br />
information can properly be observed by borrowers, a risk-based deposit insurance scheme<br />
is in place, and appropriate capital requirements are in place, then the increase of<br />
competition may not lead to higher risk-taking by banks.<br />
Another strand of the banking literature investigates the impact of competition on bank<br />
risk-taking from the perspective of asymmetric information theories. One of the problems<br />
faced by banks in the <strong>financial</strong> intermediation process is the adverse selection, where banks