Competition, Efficiency, and Soundness in Banking

An Industrial Organization Perspective

K. Schaeck, M. Cihák

Research output: Working paperDiscussion paperOther research output

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Abstract

How can competition enhance bank soundness? Does competition improve soundness via the efficiency channel? Do banks heterogeneously respond to competition? To answer these questions, we exploit an innovative measure of competition [Boone, J., A new way to measure competition, EconJnl, Vol. 118, pp. 1245-1261] that captures the reallocation of profits from inefficient banks to their efficient counterparts. Based on two complementary datasets for Europe and the U.S., we first establish that the new competition indicator captures a broad variety of other characteristics of competition in a consistent manner. Second, we verify that competition increases efficiency. Third, we present novel evidence that efficiency is the conduit through which competition contributes to bank soundness. In a final examination of banks’ heterogeneous responses to competition, we find that smaller banks’ soundness measures respond more strongly to competition than larger banks’ soundness measures, and two-stage quantile regressions indicate that the soundness-enhancing effect of competition is larger in magnitude for sound banks than for fragile banks.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages44
Volume2010-68S
Publication statusPublished - 2010

Publication series

NameCentER Discussion Paper
Volume2010-68S

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Banking
Industrial organization
Reallocation
Profit
Quantile regression

Keywords

  • bank competition
  • efficiency
  • soundness
  • Boone indicator
  • quantile regression

Cite this

Schaeck, K., & Cihák, M. (2010). Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective. (CentER Discussion Paper; Vol. 2010-68S). Tilburg: Finance.
Schaeck, K. ; Cihák, M. / Competition, Efficiency, and Soundness in Banking : An Industrial Organization Perspective. Tilburg : Finance, 2010. (CentER Discussion Paper).
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Schaeck, K & Cihák, M 2010 'Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective' CentER Discussion Paper, vol. 2010-68S, Finance, Tilburg.

Competition, Efficiency, and Soundness in Banking : An Industrial Organization Perspective. / Schaeck, K.; Cihák, M.

Tilburg : Finance, 2010. (CentER Discussion Paper; Vol. 2010-68S).

Research output: Working paperDiscussion paperOther research output

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T1 - Competition, Efficiency, and Soundness in Banking

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AB - How can competition enhance bank soundness? Does competition improve soundness via the efficiency channel? Do banks heterogeneously respond to competition? To answer these questions, we exploit an innovative measure of competition [Boone, J., A new way to measure competition, EconJnl, Vol. 118, pp. 1245-1261] that captures the reallocation of profits from inefficient banks to their efficient counterparts. Based on two complementary datasets for Europe and the U.S., we first establish that the new competition indicator captures a broad variety of other characteristics of competition in a consistent manner. Second, we verify that competition increases efficiency. Third, we present novel evidence that efficiency is the conduit through which competition contributes to bank soundness. In a final examination of banks’ heterogeneous responses to competition, we find that smaller banks’ soundness measures respond more strongly to competition than larger banks’ soundness measures, and two-stage quantile regressions indicate that the soundness-enhancing effect of competition is larger in magnitude for sound banks than for fragile banks.

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KW - efficiency

KW - soundness

KW - Boone indicator

KW - quantile regression

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Schaeck K, Cihák M. Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective. Tilburg: Finance. 2010. (CentER Discussion Paper).