Considerations for bank competition, economic fragility & stability

By Richard Rambarran and Shaleeza Shaw

Since the conception of capitalism, competition has been the driver of economic growth, development and unprecedented rise in living standards. Every firm aims to successfully compete on the market, outdoing each other and possibly acquiring others. However, banks as entities are unique.

This perspective is grounded in the nature of the products offered: on the liability side, liquidity and means of payments; on the asset side, credit and again liquidity.

Scholars have articulated that competition works differently in banking since unlike other economic sectors where the exit of one firm has no negative impact on the sector and rivals stand to benefit from the collapse of a firm; the failure of a significant bank can possibly lead to systemic instability.

This contagion is magnified if the failing bank has significant liabilities with other banks. As such, the health of the banking sector becomes important to the overall macroeconomic stability and creating a conducive business climate. A faultline showing up or even talks of an impending collapse are enough to cripple economic activity.

Understanding a Competitive Banking Sector

– Two Unique Views

Notwithstanding, competition in banking remains a controversial topic since it has the potential to lead to financial instability due to the inherent features of fragility and risk. This creates a unique context for the banks as private entities, where, in pursuit of their private interests and those of their stakeholders, inadvertent effects are created on the ‘public good’ of a stable economic environment.

Competitive markets unlike monopolies, maximise social welfare – that is to say that competitive markets tend to benefit everyone in society much more than a monopoly would. As banks expand and enter new markets, they achieve sizes that generate economies of scale (lower price from larger firms). As a result, customers are lured by lower prices, wider array of products matching their needs; access finance incentivizing entrepreneurship, and readily accessible bank service due to technology upgrade. It is interesting to note that research has found evidence of “excessive prices and profits” in British banking because of insufficient competition.

Economic theory promulgates that little competition may compromise bank stability since as bigger banks become larger and more diversified they tend to increase their portfolio risks, making them more susceptible to defaults. As is known, on the asset side huge risk appetite can lead to problems by banks becoming overly exposed to more than one sector thereby decelerating their ability to withstand negative shocks. Such a situation may also lead banks to a state of internal inefficiencies and increased operational risk due to slower pace of adapting to new methodologies and technologies to improve both efficiency and customer service.

However, a contrary view is that competition in the banking sector results in smaller, less diversified banks. These banks may result in more innovative methods of product delivery as they are kept ‘in check’ by their competitor. However, on the downside, these banks may not be as resilient to shocks and may not be able to offer the size of capital which is necessary for large investments.

This may be of particular concern to developing countries which have lost access to concessional international financial resources and are seeking to utilize Public-Private Partnerships as a method of leveraging domestic capital. Incidentally this has been identified as a strategy for future financing in Guyana since our graduation to upper middle-income in July 2016.  As such, one may witness a transformation in the role of the banking sector here in Guyana’s economy.

A paradox of competition in the banking sector

 An interesting phenomenon however occurs when the number of banks increases in an economy (increased competition in the banking sector). It has been observed that increasing the number of banks reduces the creditworthiness of borrowers in the economy and as such, increases the probability that a bank does not grant any loan. The lower the ‘quality of borrowers’, as competition increases, implies increased interest rates to compensate for the higher lending portfolio risk. This paradigm runs counter to the traditional proposition of economics where competition results in the maximisation of social welfare (a better outcome for all) in the long run. Notably, in the context of Guyana, the application of higher rates to compensate for higher risk is difficult to institute given the competitiveness in the banking sector for an already small market. This situation in Guyana has been somewhat abated by the introduction of a Credit Bureau in 2013 which has sensitized consumers as to the importance of having and maintaining a good credit rating.

The global economic downturn in 2008 depicted the effects of excessive risk-taking by banks on the entire economy and the significant welfare implications which may accrue as a result of this excessive risk-taking. This example makes it pellucid that bank distress affects the real sector (goods producing sector) of an economy. In the contemporary globalized economic environment, this can easily create a regional or global financial contagion – a situation where interconnected markets begin to fail due to financial distress in one area.

The best of both worlds?

– Competition & Stability

It becomes clear therefore that a purely competitive, deregulated banking sector is not conducive for stable economic growth. What is more desirable, for an improved state of social welfare, a stable economic environment and robust growth, is a healthy degree of competition between banks with adequate regulation. This is pivotal in being able to strike the delicate balance in the trade-off between competition and financial stability.

One proposition to preserve financial stability whilst maintaining a healthily competitive banking sector is that of ‘Ring fencing.’ In the context of banking, ‘ring fencing’ refers to the separating of deposits and lending functions from investment banking. This ensures that a healthily competitive commercial banking sector can exist alongside private lending agency which is able to leverage capital for investment. International banks unlike some of our local banks also have the benefit of deposit insurance coverage as an added buffer to their regulatory reserve requirements.

Within the current context of the financial landscape in Guyana where domestic banks will be required to play an increasingly important role in facilitating development financing and engaging international players to support the emerging oil and gas sector, it is a critical time to ensure that the requisite legislation is in place to preserve financial stability. Facilitating ‘ring fencing’ in the banking sector is only one such method of preserving financial stability. While the ‘Bail out’ has been adopted on a few occasions in the first world it has been flayed for its discriminate leaning towards bigger banks and encouragement of moral hazard.

Richard Rambarran – Richard Rambarran is the Executive Director of the Georgetown Chamber of Commerce & Industry and a lecturer in the Department of Economics at the University of Guyana. He holds a Masters’ degree in Economics and several certificates from the IMF on macroeconomic stability, financial programming etc.

Shaleeza Shaw – Shaleeza Shaw is the Head of Credit/Corporate Secretary of Guyana Bank for Trade and Industry Limited. She holds a Masters’ degree in Business Administration among qualifications in Banking, Law and Business Management.

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