Media Briefings

COMPETITION AMONG BANKS: A POTENTIAL THREAT TO MACROECONOMIC STABILITY

  • Published Date: December 2012

Fierce competition among banks in the mortgage market may not always be desirable, according to research by Javier Andres and Oscar Arce, published in the December 2012 issue of the Economic Journal. Their analysis suggests that more banking competition may make market economies more leveraged and therefore potentially more unstable.

The researchers note that much as in other sectors of the economy, competition in the banking industry naturally tends to improve the allocation of resources and, in this way, it has its own beneficial effect in fostering growth over the medium to long run.

But the effects of banking competition in the short run are more complex. In particular, in the context of the global financial crisis, some analysts have shown concerns about a number of potential links between banking competition and the accumulation of macro-financial imbalances.

Along these lines, in September 2008, Martin Wolf wrote in the Financial Times: ‘Most institutions that specialise in lending to the housing market will disappear into larger and more diversified entities. Less competition will mean higher margins and more costly borrowing. So be it. The UK should not want housing finance to behave as it did in the years leading up to August 2007 ever again’.

More recently, some voices have warned about the contractionary effects from lower competition between lenders on the recovery of the credit flow amid an increasing number of falling institutions in many advanced economies. One example is an October 2012 article headlined ‘Fears over US mortgages dominance’ by Robin Harding, also in the Financial Times.

Against this background, this study develops a dynamic macroeconomic model featuring a mortgage market where financing available to property buyers comes from a monopolistically competitive banking sector.

The interplay between the key pieces of the model – which include housing prices, interest rates, financial constraints and the competitive structure of the banking industry – sheds light on the potential conflicts between efficiency and stability arising from the intensity of competition in that industry.

In particular, within the logic of the model, stronger banking competition reduces the margin between lending and the borrowing rates, giving rise to two competing effects.

Lower margins spur borrowing, eventually driving up leverage. In turn, high leverage ratios tend to exacerbate the short-run response of housing prices, consumption and output in face of exogenous disturbances through the familiar net worth acceleration mechanisms.

But lower lending margins also promote a faster recovery of the borrowers’ net worth and, hence, of the economy’s spending, investment and production capacity in the face of an adverse shock.

In the end, which of the previous conflicting forces dominates depends crucially on the nature of the shock hitting the economy. Following a shock to the nominal interest rate, the former effect dominates and tougher competition among banks makes the economy more vulnerable in the face of adverse shocks through the negative link between bank margins and leverage.

But when financial shocks hit in the form of stricter credit conditions (for example, lower loan-to-value ratios), then preserving high-level competition among lenders helps a faster recovery of credit, investments and growth, through its moderating effect on margins.

Thus, the main policy implication of this study is that unlike what is commonly accepted in most other sectors in the economy, stronger competition among banks in the mortgage market may not have unequivocally beneficial effects on the macro-economy in the short run. Key to this ambiguity is the idea that more competition among banks makes market economies more leveraged and hence more vulnerable to exogenous shocks.

ENDS

Notes for editors: Banking Competition, Housing Prices and Macroeconomic Stability by Javier Andres and Oscar Arce is published in the December 2012 issue of the Economic Journal.

Javier Andres is at the University of Valencia and the Banco de España. Oscar Arce is at the Banco de España.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com); or Oscar Arce via email: o.arce@bde.es