Market power and stability of financial institutions: evidence from the Italian banking sector

Author:Cristian Barra, Roberto Zotti
Position:Department of Economics and Statistics, Faculty of Economics, University of Salerno, Fisciano, Italy

Purpose This paper aims to explore the relationship between bank market power and stability of financial institutions in Italy between 2001 and 2012. The authors first test the existence of a U-shaped relationship between market power and financial stability. Second, they regress the market share indicator on bank risk-taking to underline whether financial stability is affected by increasing or decreasing the market power of banks. Third, they... (see full summary)

Market power and stability of
nancial institutions: evidence
from the Italian banking sector
Cristian Barra
Department of Economics and Statistics, Faculty of Economics,
University of Salerno, Fisciano, Italy, and
Roberto Zotti
Department of Economics and Statistics Cognetti de Martiis,
University of Turin, Turin, Italy
Purpose This paper aimsto explore the relationship between bank market powerand stability of nancial
institutions in Italy between 2001 and 2012. The authors rst test the existence of a U-shapedrelationship
between market power and nancial stability.Second, they regress the market share indicator on bank risk-
taking to underline whether nancial stability is affected by increasing or decreasing the market power of
banks. Third, they explorewhether this relationship is affected by the size, level of capitalization and credit
insolvencyof banks.
Design/methodology/approach Relying on highly territorially disaggregated data at labor market
areas level, the authorsestimate the impact of bank market power and other explanatory variableson a proxy
of risk taking behavior such as the banking stability inefciencyderived simultaneously from the
estimation of a stability stochasticfrontier. Bank market power is taken into account through an individual
measure based on loans. Financialstability is calculated through the Z-score. The authors use, asrisk-taking
measure,the stability inefciency whose estimation approach is the stochasticfrontier analysis.
Findings The empirical evidenceshows that the inefciency of nancial stability is foundto be U-shaped
related with respect to the measure of market power. Bank size is an essential factor in explaining the
relationship between bank marketpower and risk-taking. Cooperative banks have fewer incentives to gain
market power to better performin term of risks. The reform of the cooperative banks that took recently place
in Italy is not supportedby the data.
Originality/value The relationship between bank market power and nancial stability has been
analyzed using a rich sample of cooperative, commercial and popular banks in Italy over the 2001-2012
period. The authors rely on labor marketareas being sub-regional geographical areas where the bulk of the
labor force lives and works. The paper investigates the market power-stability link considering both
cooperativeand non-cooperative banks. Indeed, specic attentionhas been paid on cooperative banks because
of their mission in favor of the local communityas only few studies, to the best of the authorsknowledge,
examine cooperativebanking.
Keywords Bank regulation, Local banks, Market power, Financial stability
Paper type Research paper
1. Introduction
The relationship between market power, bank efciency and stability or fragility of
nancial institutions is widely debated but controversial among policymakers and
academics. Especially in times of nancial turmoil, the trade-off between market power
JEL classication G21, D21, G28, C14
Power and
stability of
Received5 May 2019
Revised11 September 2019
Accepted30 October 2019
Journalof Financial Regulation
Vol.28 No. 2, 2020
pp. 235-265
© Emerald Publishing Limited
DOI 10.1108/JFRC-05-2019-0055
The current issue and full text archive of this journal is available on Emerald Insight at:
concerns and stability considerations become particularly acute.Banks with greater market
power are perceived by the market as less risky and also have a better capitalization prole
with respect to the distribution of their returns (Lapteacru, 2017). Having more market
power allows banks to earn higherprots that can serve as capital buffers (Allen and Gale,
2004;Boyd et al.,2004) and to increase resilience to external macroeconomic and liquidity
shocks. This also allows banksto collect more private information (Hauswald and Marquez,
2006), thus reducing the risk of loan defaults. Highermarket power could have incremental
economic effects, decreasing bank fragility, through its impact on liquidity creation
(Horvath et al.,2016). Moreover, it may strengthen the solvency of some institutions, thus
encouraging the stabilityof the banking system at aggregate level. Banks, consequentlyand
to keep their prots unaltered, could take less risky policies, decreasing the likelihood of
failure. When nancial institutions have less power in the market, their average credit
quality decreases due to the fact that when banks compete for deposits, interest rates fall
and, due to the contraction of franchise values, banks have less to lose and therefore
undertake more risk-taking strategies(Marcus, 1984). Market power has been also linked to
higher fragility of the banking system. Indeed, nancial institutions with more market
power are encouraged to increase their interest rates and thus originate riskier loans
(Caminal and Matutes, 2002;Boyd and De Nicolò, 2005). Such banks are more likely to
engage higher moral hazard incentives to exploit government bailout turning into too-big-
to-failinstitutions (Berger and Mester, 2003;Mishkin, 2006;Barth et al.,2012), therefore
destabilizing the stabilityof the banking system. Higher bank market power increasesnon-
performing loans, even though such trends are associated with a decrease in bank default
risk. Indeed, the levels of capitalizationare enriched in banks with higher market power and
are sufcient enough to cover an increase in non-performing loans; hence, bank stability is
not affected (Berger et al.,2009).
Several empirical studies provide support for both arguments. An increasein the degree
of market power leads to greater bank stability and enhanced protefciency, despite
signicant cost efciency losses (Ariss, 2010) and does not inuence bank insolvency risks
(Levy-Yeyati and Micco, 2007). A moderate level of bank market power is associated with
higher bank stability (Liu et al.,2012) as well as lower market power induces bank risk
exposure after controlling for macroeconomic, bank-specic, regulatory and institutional
factors (Fu et al., 2014). Empirical ndings highlight that greater market power in the
banking market results in higherinstability (Soedarmono et al.,2013). Banks with more loan
market power are in a position to charge higher rates for loan customers. This makes it
harder for borrowers to repay loans, thereby exacerbating moral hazard incentives to shift
into riskier projects and possibly resulting in a riskier set of bank clients due to adverse
selection considerations (Boyd and De Nicolò, 2005). Welfare gains associated with a
reduction of market power are greater than the loss of bank cost efciency underlining the
importance of economic policy measures aimed at removing the barriers to outside
competition (Maudos and de Guevara, 2007). When it comes to explain the determinant of
market power, those with the greatest explanatory power are size, efciency and
specialization while concentration is not signicant (de Guevara and Maudos, 2007). Bank
size is among the main variables with a positive and signicant effect on market power.
Indeed, larger banks enjoy greater market power due to either cost advantages or to their
capacity to impose higher prices(de Guevara et al., 2005). The empirical evidence also shows
that market power maybe small even in markets with only one bank, conrming that in this
sector concentration and competition can coexist. In spite of the advantageous condition,
monopolistic banks are able to exploit only partially their market power, whose estimated
level is far from the typical monopoly conduct (Coccorese, 2009). Consideration needs to be

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