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Balancing the Trade-Offs Between Competition and Stability Premium

Private Banks & Public Policy

Authors: Vives, Xavier

Date: Third Quarter 2017

Tags: PPP, public-private partnership, banking, regulation, competition

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The prosecuted cartel cases brought by U.S. and E.U. authorities for manipulation of exchange rates and benchmark interest rates (e.g., Libor) provide good examples of how competition policy can help curb misconduct in the banking and financial sectors. Regulation and supervision are necessary for these sectors to function properly. But how much is too much? And how to design policies that adequately protect consumer welfare and market stability, without getting in the way of healthy competition?

Certainly, competition is good for society, helping to create efficient, dynamic markets. But there is a trade-off between competition and financial stability -- a trade-off that is not so easy to regulate away.

To deal with this, the specificity of competition policy must be recognized. Regulation must be well coordinated, using a holistic approach that takes account of the various conduct and structural instruments involved, while at the same time ensuring that the different agencies responsible for regulation and competition policy remain independent from each other.

This article -- based on my recent book, Competition and Stability in Banking: The Role of Regulation and Competition Policy (Princeton University Press, 2016) -- presents some key challenges that bankers and regulators face in trying to manage the trade-offs between competition and stability. I also derive some important policy implications for both public- and private-sector actors, so that society can reap the genuine benefits of competition: efficiency, innovation, growth and consumer welfare, in order to build trust in the banking sector again.

The Specificity of Competition in Banking
Competition nurtures efficiency and innovation, and delivers consumer welfare -- when regulation is appropriate. Competition policy, therefore, should be enforced to guarantee competitive financial input for the economy and to foster growth. Furthermore, vigorous conduct enforcement may help restore diminished levels of trust following the 2007-2009 financial crisis.

During a crisis, the role of competition policy is to keep markets open and to keep distortions that have been introduced by rescue packages in check. The immediate aim is to stabilize the system, promote the exit of failed institutions, and remove artificial barriers to entry. Competition policy may also play an advocacy role, concentrating minds on innovation and growth, and avoiding overregulation.

Given the systemic consequences of banking failures, it is important to recognize the unique position of banks in this equation. Competition policy in banking must balance short-term stability objectives with long-term competitive vigor, particularly with regard to the following aspects:

STATE AID. Although state aid aimed at stemming the spread of a crisis benefits the whole banking sector as well as society, it leads to distortions in competition that need to be addressed by policy. State ownership has proved distortionary, and intermediate ownership structures -- such as savings banks and mutual banks -- have often proved to be too weak to confront crises. In many cases, too much political interference in public and semipublic entities has led to trouble.

TOO BIG TO FAIL (TBTF). TBTF policies also lead to distortions in competition. Institutions falling under the TBTF umbrella enjoy an advantage, in that there is an implicit guarantee of state aid for them. This gives rise to moral hazard -- when a person is prepared to take more risks because someone else bears the cost of his or her risk-taking.

To avoid this, competition policy should be designed to discourage bankers from taking excessive risk, imposing behavioral and structural measures on entities that obtain help. The European Commission, for example, has adopted stricter measures related to restructuring procedures -- restricting certain business activities that fall outside a regulated banking core. Moreover, once an institution has been bailed out, the E.U. competition authority demands a demonstrable commitment to financial discipline.

Competition policy may also prevent the consolidation of anticompetitive market structures with banks that are TBTF and therefore cannot exit the market. Divestitures of a large entity that has been bailed out could go so far as to require its breakup.

MERGER CONTROL. To preserve a competitive market structure in the long run, merger policy should seek an optimal degree of concentration, easing entry, but in a prudent manner.

Whether extra allowance for market power or concentration should be made in banking is an open question. In traditional banking, the case for an intermediate level of concentration can be made, since the link between market structure and competition is stronger. In market-based banking, a natural oligopoly structure may emerge, making prudent restrictions more necessary here.

In the event of a financial crisis, a usual recipe is to force troubled entities to merge with sound ones. There are two potential problems with this: first, the merged entity may become TBTF; and second, this strategy may give rise to anticompetitive market structures. A better alternative would be to nationalize the distressed bank and privatize it later as a viable competitor.

Preferably, merger controls should be in place to avoid TBTF entities forming in the first place, since such entities will only end up distorting competition later on. Sometimes a merger may be favored to reduce excess capacity and decrease overheads. Other times, a temporary increase in market power may be allowed in order to rebuild the charter values of better banks. In general, however, competition policy may need to impose divestitures to avoid competitive distortions, foster entry into the market and reestablish competitive structures.

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