Aurora Borealis
1 July 2014 CFA Institute Journal Review

Competition and Financial Stability in European Cooperative Banks (Digest Summary)

  1. Chen Sui

Cooperative banks account for one-fifth of EU bank deposits and loans, yet little is known about the relationship between bank stability and competition for these institutions. The authors analyze data for these banks from 1998 to 2009 and determine that there is a positive relationship between competition and stability.

What’s Inside?

Applying regression techniques commonly used in economics, the authors show that there is a positive relationship between market competition and stability for cooperative banks. They are also able to show that this relationship holds true even when markets are highly stressed (e.g., during the 2008 financial crisis). Finally, they are able to find a positive relationship between the level of homogeneity in the cooperative banking system and its stability.

How Is This Research Useful to Practitioners?

Retail and investment bank stability has been the focus of much academic research since the 2008 financial crisis, yet cooperative banks have largely been ignored, despite accounting for one-fifth of EU bank deposits and loans. The authors address this lack of attention by focusing their research efforts on understanding how competition affects cooperative bank stability.

There are two concurrent views on why competition affects stability. The first is the fragility view, which argues that higher competition leads to increased risk-taking activities. The second is the competition-stability view, which states that in a low-competition environment, the market power of the banks will cause them to raise interest rates on loans so that only more risky projects are financed, negatively affecting the stability of the banking system.

The authors’ main finding is that there is a positive relationship between competition and stability of EU cooperative banks, which supports the competition-stability view. This finding is also consistent with past studies on commercial banking stability.

Another important finding is that there is a positive relationship between the level of homogeneity in the cooperative banking system and the stability of the system. This finding supports the too-many-to-fail concept, whereby there are incentives for banks to increase the risk of many banks failing concurrently, which increases the chances of a bailout.

The authors then turn to the effect of the financial crisis on European cooperative banks and show that the crisis does not seem to have affected the relationship between competition and stability.

How Did the Authors Conduct This Research?

The authors assess the relationship between competition and bank soundness between 1998 and 2009 using empirical evidence gathered from the five largest countries by cooperative bank deposits and loans, which account for 85% of total assets held by EU cooperative banks. Competition between banks is estimated by using the Lerner Index of monopoly power, which represents the extent to which market power allows firms to fix a price higher than marginal cost.

Bank stability is measured by calculating a Z-score based on the capital-to-asset ratio and the return on assets. The Z-score captures the number of standard deviations by which returns have to diminish to deplete the equity of the bank.

The authors use the popular Granger causality technique to investigate the relationship between market competition as measured by the Lerner Index and stability as measured by the Z-score. The limitations of the techniques used are addressed, such as by increasing the number of variables to account for specification bias and spurious causality. Care is also taken so that the results are not skewed by such factors as differences between bank-level fundamentals, individual country conditions, and dynamic changes in the environment.

One potential limitation is that the dataset does not extend far past the end of the financial crisis, the effects of which have continued for many months after the crisis itself passed.

Abstractor’s Viewpoint

The authors remind readers that cooperative banks are significant in the EU—not only because they account for one-fifth of the deposits and loans in the EU but also because of the close community ties that they have. As such, it is important for policymakers to have a deep understanding of the characteristics of the sector when designing and implementing regulations.

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