Competition and Bank Risk

1. Competition and Bank Risk Michiel van Leuvensteijn David Marques-Ibanez Yener Altunbaṣ The Effect of Securitization and Bank Capital The opinions are those of the authors only and do not necessarily involve their institutions Michiel van Leuvensteijn – Monitor Financial Sector – 29 november 2016

2. Objective of this paper: • To investigate the effect of competition on bank risk; • focus on how two major factors—securitization and bank capital—that had a large impact on the banking business prior to the crisis affected the competition and bank risk nexus;

3. Objective of this paper: • In more competitive markets: • Hypothesis I: Securitisation, thus i) banks may have less incentive to monitor their earning asset portfolio; ii) banks might also respond to the static reduction in risks due to securitization by taking on new risks.  Bank risk rises? • Hypothesis II: Bank capital may affect bank risk less.  Bank risk reduced?

4. Key Results • securitization amplifies the effects of competition on bank risk, especially for the systemic dimension of bank risk. • higher levels of bank capital do not contribute to buffer the direct effect of competition on bank risk. • more competition seems to increase the probability of receiving financial support during the crisis, independently of the measure of competition chosen.

5. Theory • The economic theory is unclear on the effect of competition on bank risk. • One strand of literature: competition endangers financial stability. Increased competition for loans would erode profits, lowers the market power of banks, depress their charter value and encourage banks to expand their business and take on new risks. • Other strand of literature: Competition would lower banks’ lending rates attracting less risky borrowers, thereby raising their profits and their charter value so they have fewer incentives to take on new risks.

6. Data & Model • Bank level data from EU15 and US • Quarterly data over 2003-2009 • three alternative measures of bank risk • three different competition measures • Country: GDP Growth or dummies • Bank specific characteristics & interactions • capture the impact of competition through securitization and capital on bank risk

7. Data: Construction • Using the existing literature (Boone 2008 and Van Leuvensteijn et al. 2011), we construct a measure of competition (COMP). • Hence we include 5 bank-specific characteristics (Altunbas et al., 2011): securitization (SEC), capital (CAP), size (SIZE), loan growth (EXLEND) and deposits (DEP). • Also, we interact competition and two main bank specific characteristics: securitization (SEC) and capital (CAP) to assess their connection with competition (COMP*X).

8. Strategy: Hypotheses : Competition => Securitization => Bank risk ? Competition => Bank capital => Bank risk Bank risk: financial support Securitization/ total assets size Excess lending Competition Boone indicator Tier I capital/ total assets Deposits 2002 Time 2007 2009

9. Strategy: • We exploit the 2007-2009 crisis and consider whether the ex-ante cross-sectional variability in bank characteristics and competitive conditions prior to the crisis are related to the likelihood of a bank rescue. • We model the probability of a bank belonging to the group of rescued institutions during the crisis. We create a dependent variable as a dummy (Risk) that takes the value of 1 if the bank had any form of financial support during the crisis.

10. Results (I):

11. Results (II): IV = Average CAP en SEC of other banks (Laeven and Levine, 2009)

12. Summing up: • Results robust for different measures of competition and Risk (systemic risk) • Competition encourage banks making greater use of securitization activity to have more incentives to increase their risk profile. These banks are more likely to be rescued after the crisis. • As competition becomes stronger, even high capital levels do not buffer the direct impact of competition on bank risk. • Excessive reliance on bank capital may not ensure financial stability. • Supervisory authorities should cooperate with competition agencies particularly when evaluating the financial stability implications of bank capital regulation or securitization.