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Competition in the financial sector can have a positive impact on efficiency. At the same time, bank can take on greater risks, thereby jeopardising the stability of the system. The theoretical and empirical literature provides no clear indication as to whether the correlation between competition and financial stability is positive or negative.
Current research suggests that greater competition may have a destabilising effect, making it necessary to have an adequate level of regulation in place. From a financial stability perspective, the debate should not be misinterpreted as an appeal for less competition. Instead, it is about identifying the root causes of systemic risk that may become much more apparent, particularly amid fierce competition.
Technological change is a major driver of competition and stability. As things currently stand, it is not clear what form the technologically transformed financial system of the future will take, or whether FinTech and BigTech will play an important role in it.
Up to now, traditional financial intermediaries such as banks, insurers and investment funds have dominated the German financial system, but competitive processes could be disruptive.
In addition, the financial market reforms of recent years will give rise to shifts in the competitive structure. Banks that have previously benefited from (implicit) government guarantees will likely see their market shares shrink. Institutions lacking a sustainable business model will, like every other enterprise in their position, ultimately be forced to exit the market.
All the more reason, then, to ensure that the banking sector as a whole can withstand headwinds. A key prerequisite in this regard is that it has sufficient capital. Higher capital levels yield competitive advantages, as they make it possible to finance investment and innovations while simultaneously serving as protection against risk.
The German economy is currently in good shape. It is precisely while the going is good that the financial system should prepare itself to ensure that, when the situation takes a turn for the worse – in the event of a cyclical downturn, for instance – it remains able to exercise its key economic functions. At the end of the day, economic models cannot fully gauge future global risks, economic risks, or technological changes and their implications for the financial sector. We need to take this model uncertainty into account when assessing financial stability.