Finance: Research, Policy and Anecdotes

Competition and Regulation in Financial Markets

I participated in an interesting conference on Competition and Regulation in Financial Markets at the Bank of England (co-organized by CEPR) earlier this week.  Competition is with no doubt one of the most important, controversial but also broadest concepts in finance.  While we teach our students in Introductory Economics the benefits of competition for efficiency, resource allocation and innovation, there are quite some countervailing effects in finance.  Many of these are related to information asymmetries (and thus the necessary incentives to create such information) and the limited liability character.  This has resulted in a long-standing paradigm that too much competition is detrimental to stability in banking, as it undermines franchise values and entices banks to take aggressive risks resulting in a higher failure probability. However, there are opposing theories focusing on the effect of lower interest rates in more competitive banking system on reducing agency problems between lenders and borrowers and thus enhancing stability. The empirical evidence has not been clear cut, partly related to differences in the measurement of both competition (market structure measures, behavioural measures or regulatory gauges) and fragility (market- or account-based, idiosyncratic or systemic).

One important dimension is the interaction between regulation and competition.  As shown in my 2013 paper with Olivier De Jonghe and Glenn Schepens, the institutional and regulatory framework has important consequences for the degree to which higher competition results in higher or lower stability and the strength of this relationship.  One can also see this from the viewpoint of regulatory tools, as shown in a paper by David Martinez Miera and Eva Schliephake, presented at the conference: the optimal level of capital requirements depends on the degree of competition in the banking system and from outside the banking system.

Another question that came up in discussions is that of reducing moral hazard in banking, i.e. the risk that banks or financial market participants in general take aggressive risks, not taking into account the externalities that their possible failure imposes on the rest of the financial system and the real economy. While capital requirements, regulatory restrictions and an effective bank resolution framework have gained quite a lot of attention in the wake of the crisis, other areas such as whistle blower rewards and the effectiveness of fines have received less attention although there seems quite some evidence (according to Giancarlo Spagnolo) that whistle blower rewards can be quite effective.  In the context of fines, I am getting more and more convinced that a return to more personal liability for risk decision takers seems the most straightforward and maybe most effective tool (in spite of possible downsides such as reducing the amount of risk taking below its optimum).

As in other areas of the economy, it is important to define the appropriate market to assess competition.  This also implies that one has to look beyond banking or maybe even outside the regulatory perimeter.  Recent developments have provided ample examples.  In the area of payment services, fintech companies have provided innovative solutions to get around excessive foreign exchange charges and more convenient transaction services.  Peer-to-peer lending and crowdfunding platforms have stepped in where banks have withdrawn (or never have been) in micro- and small business lending. While these new providers can provide the necessary competition to enhance efficiency and thus improve financial service provision, it is clear that they come with risk (especially when it comes to intermediation and lending) and thus the question of regulatory responses arises.  And there is a clear trade-off of not suppressing innovation, while at the same time stepping in in-time to avoid fragility risks building up.