Competition Vs Stability in Banking: Is There a Sweet Spot?

Experts gather in New York to review the state of banking

18/10/2016 New York

Prof. Xavier Vives

Competition and stability in banking can be achieved with carefully coordinated regulations designed to match current market conditions, says Prof. Xavier Vives / Photo: Julie Skarratt

Eight years since the crisis and the pressure for banks to be competitive is back on, posing concerns for many. Over the years, there have been a number of developments in the industry, from shadow banking to consolidation. And, while we seem to have regained some stability, there is still the threat of risk as banking moves through its usual cycle.

Prof. Xavier Vives was joined in IESE New York by a panel of experts to discuss whether we can break this cycle.

There is an inherent tension in banking between the desire for competition and the need for economic stability. Institutional responses to this have taken the form of strict regulatory policies on one end of the spectrum, and competition-based approaches on the other.

Nevertheless, we can have both competition and stability in banking, argues Vives, but only in the presence of carefully coordinated regulations, designed to match current market conditions.

A Vicious Cycle

Economic crises are generally cyclical in nature, explains Prof. Patrick Bolton of Columbia University. More often than not, an economic crisis will usher in a period of increased regulation. Around ten to twenty years later, developments begin to arise outside the realm of the now heavily regulated banking sector, thereby rendering it uncompetitive. In response, the banking sector is deregulated to increase its competitiveness, leading to another economic crisis. The cycle continues.

Regulators naturally desire plenty of healthy competition. But the prevalence of economic frictions that give rise to excessive risk-taking call for a trade-off of policy objectives and the realities of market failures.

Unhealthy Competition - Shadow Banks

Given the nature of the cycle, it’s important that we expand our view of competition, says Bolton. It’s not just about competition between banks, but also the competition between the banking and non-banking sectors, including shadow banks.

Tobias Adrian, Associate Director of Research at the New York Federal Reserve Bank, identified shadow banking as a crucial component in the 2007-2009 economic crisis. By increasing competition against the bank sector, while simultaneously allowing banks to generate profits, shadow banks encouraged excessive risk-taking.

“In retrospect, this is what the machine of securitization was doing,” says Adrian. In the securitization process, economic frictions, such as moral hazard problems and asymmetric information, led to the trading of assets at prices that did not reflect their true riskiness.

Raising the Bar with Accounting

Since the economic crisis, the introduction of higher-quality capital and regulatory reforms has changed the economics of shadow banking considerably. That being said, securitization certainly still exists, and accounting is not always aligned with the public good.

Accounting standards inevitably color the view of products and markets that investors and analysts have. And, according to Adrian, contrary to popular belief, these accounting standards have not always been very helpful in assessing the economic mechanisms at play in certain companies.

“Insurance companies and banks can take on risk along dimensions that look very safe on the balance sheet but, in fact, allow them to take on more risk,” he says. This is a key feature of shadow banking: exploiting the capacity to increase risk exposure while maintaining an image of security and reliability.

Since the crisis, some change has been achieved in the competitive environment of banking with respect to securitization activity. Improved accounting standards serve to keep securitization processes in check.

Finding the Sweet Spot

Today, pressure for banks to compete against non-banks, on sometimes very unequal terms, is beginning to resurface as financial activity shifts away from the regulated banking system.

In his new book, Competition and Stability in Banking, Professor Vives proposes a solution to this problem: a movement away from the regulation of institutions, toward the supervision of economics functions. In this way, Vives argues, if other institutions, such as shadow banks, were to provide similar or parallel functions, the established regulations would still apply.

Considering the tendency of economic history to repeat itself, Bolton is less optimistic than Vives that we can escape the cycle with the right regulation, to reap the benefits of competition.

Politics Matter

Finally, there is the question of the political economy. “It is clear that government subsidies and direct fiscal interventions in the financial system can pose major issues,” says Patricia Mosser, Senior Research Scholar and Senior Fellow at SIPA (Columbia University). Nevertheless, politics do matter quite a bit for banks when it comes to understanding competition and regulation.

“There is a significant number of political decisions that end up having system-wide impacts on both competition and regulation,” Mosser says. Understanding the politics is thus critical to understanding the competition policy and, in some cases, the perimeter of regulation, of an economy.

We are in the midst of a presidential election in which economic policy and the impacts of the financial crisis are of utmost importance. Adopting a political lens is not only a useful, but also a timely tool for addressing the impacts of competition and regulation on economic stability.