02 June 2013

Lev Ratnovski: New challenges for bank competition policy

Although the traditional policy tools are rules on entry/exit and the consolidation of banks, there are other, newer ways in which competition policy can support financial stability: dealing with too-big-to fail and other structural issues in banking, as well as facilitating crisis management.

Bank competition policy has been a focus of much research and policy debate. The reason for this is the special nature of banks. In the non-financial sector, competition policy mainly focuses on efficiency (competitive pricing). Yet for banks there is another relevant dimension: systemic risk. When the degree of competition adversely affects banks’ risk-taking incentives, bank competition policy should have a macroprudential component.

The theoretical predictions and empirical results on the link between bank competition, risk-taking, and stability are ambiguous. But on net they suggest that an intermediate degree of bank competition is optimal. Too much competition erodes the charter values of banks and creates incentives for risk-taking. Too little competition reduces efficiency and may lead to the too-big-to-fail problem...

In a recent paper, I examine new ways in which bank competition policy can support financial stability. My analysis suggests three priorities:

• First, help address ‘too-big-to-fail’.

The too-big-to-fail problem is a major prudential concern (Haldane 2013). The Basel III capital surcharges for systemically important banks (up to 2.5 per cent of risk-weighted assets) might be too small to give banks incentives to shrink. Bank competition policy can help address too-big-to-fail.

A blunt approach would be to use competition-policy tools to directly restrict bank size (by limiting mergers, forcing spin-offs, etc.). However it may be hard to restrict size on competitive grounds when banking is contestable and efficient. And since we do not know much about optimal bank size, blunt restrictions may have unintended effects.

A more nuanced approach would be price-based. Competition in banking is distorted because large banks have access to cheaper funding than small banks (thanks to the too-big-to-fail guarantee, as much as 80 basis points cheaper; Ueda and Weder di Mauro 2012). Levelling the playing field is a natural area for competition policy. The funding advantage of too-big-to-fail banks can be offset through equivalent taxes or fines (think of a tax on wholesale funding of banks, with a rate that is increasing in bank size). This competition policy measure, as a by-product, would reduce excess incentives for banks to grow, reducing the too-big-to-fail problem.

• Interaction with structural policies.

Recent structural policy initiatives aim to restrict bank or non-bank activities that contribute to systemic risk (Gambacorta and van Rixtel 2013). These limits would have important interactions with competition policy.

The Volcker Rule and the Vickers and Liikanen proposals suggest restricting market-based and, to an extent, international activities of banks. The rationale is that such activities may contribute disproportionately to systemic risk (Boot and Ratnovski 2013). From a competition perspective, these restrictions might also be desirable. They would allow authorities to use different approaches to less contestable (core) and more contestable (market-based and international) sectors of banking, resulting in a more precise competition policy.

Another structural problem highlighted by the Crisis is excess competition for retail deposits. Retail deposits are the most stable source of bank funding (Huang and Ratnovski 2009). When deposits are scarce, banks have to rely on unstable wholesale funding. A common reason for the scarcity of deposits is excess competition for household savings – from insurance companies or asset managers (as in Australia or the Nordics) or from local savings banks with implicit public guarantees (as in Germany). Competition policy may help by pressuring governments to level the playing field – deal with implicit guarantees and lax regulation of non-banks.

• Competition policy and crisis management.

The Crisis put into sharp relief possible conflicts between bank competition policy and crisis management (Vickers 2010). Normally, competition policy advocates limited government involvement in banks in order to maintain a level playing field. Yet, crisis management may require governments to take ownership in banks or offer banks guarantees in order to maintain financial stability and the capacity to lend. Also, governments may need to exercise control over banks to direct their restructuring.

In such exceptional circumstances, competition policy should acknowledge the trade-off between preserving the level playing field versus effective bank resolution, and aim for a balance. Also, competition policy might need to temporarily allow higher banking-system concentration, when that is necessary to allow banks to rebuild charter values or to facilitate the shrinking of a previously over-expanded banking-system.

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