The Banking Conundrum

BARCELONA – Central bankers and regulators tend to worry that too much competition in the financial sector increases instability and the risk of systemic failure. Competition authorities, on the other hand, tend to believe that the more competition, the better. Both can’t be right.

There is a trade-off between competition and stability. Indeed, greater competitive pressure may increase the fragility of banks’ balance sheets and make investors more prone to panics. It may also erode the charter value of institutions.

A bank with thin margins and limited liability does not have much to lose, and will tend to gamble – a tendency that is exacerbated by deposit insurance and too-big-to-fail policies. The result will be more incentives to assume risk. Indeed, for banks close to the failure point in liberalized systems, the evidence of perverse risk-taking incentives is overwhelming.

That is why crises began to increase in number and severity after financial systems in the developed world started to liberalize in the 1970’s, beginning in the United States. This new vulnerability stands in stark contrast to the stability of the over-regulated post-World War II period. The crises in the US in the 1980’s (caused by the savings-and-loan institutions known as “thrifts”), and in Japan and Scandinavia in the 1990’s, showed that financial liberalization without proper regulation induces instability.