Bank concentration, competition and financial stability nexus in the East African Community: is there a trade-off?

Abstract

This paper examines bank concentration, competition, and financial stability nexus across five emerging countries (Kenya, Tanzania, Uganda, Rwanda and Burundi) within the East African Community (EAC). The methodological approach applied provides a critical and original contribution to the existing literature by testing the various theories explaining the relationships between bank concentration, competition, and stability. A two-step system Generalised Methods of Moments (GMM) is employed on a sample of 149 banks with 1,805 annual observations over the period 2001–2018. The findings reveal that high concentration and low competition lead to more financial stability and less probability of bank default risk. In addition, a non-linear relationship between competition and stability is not observed, revealing that greater competition undermines bank stability and makes banks more vulnerable to default risk. The findings thus lend to support the concentration-stability hypothesis that greater market power leads to more bank stability even after controlling for bank-specific, industry, and macroeconomic variables. The findings provide a significant policy contribution on the trade-off between bank concentration and competition, and the evaluation of financial stability.

Keywords:

• Bank Concentration
• Competition
• Financial Stability
• System GMM
• East African Community

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. Boyd et al. (2006) present that the effect of riskier portfolios is more than the revenues realized from the concentrated banking sectors. In addition, empirical evidence suggest that lack of competition leads to high concentration and increased market power which can hinder the level of bank efficiency and stability in an economy especially if some banks are too big to fail (Allen & Gale, 2004; Boyd & De Nicolò, 2005; Goetz, 2018; Ibrahim et al., 2019; Schaeck & Cihák, 2014). On the hand, Martinez-Miera and Repullo (2010) and (Dutta & Saha, 2021b) observe a non-linear relationship between competition and stability.

2. While related studies such as Kouki and Al-Nasser (2017), Oduor et al. (2017), and Akande et al. (2018) are focused in Africa, the current study considers one economic bloc (EAC) characterized by regional integration initiatives where the level of interconnectedness has increased and any bank shock might catapult tremendous effects to the entire region. In addition, both structural and non-structural measures are employed unlike the prior studies.

3. The Two-step system GMM is estimated in STATA-15 using the xtabond2 command (Roodman, 2009) and Windmeijer (2005) corrected standard errors, small sample and instrument collapse options. To circumvent the effect of a large number of instruments which make the results of GMM misleading, we ensure the number of instruments do not exceed the number of groups and also use a subset of the instrument matrix available. Financial stability, bank concentration, competition, capitalisation, diversification, loans/assets, and bank size are treated as endogenous variables. These variables are instrumented with GMM-style instruments, i.e., the variables are lagged in levels. Financial structure and macroeconomic variables are treated as exogenous variables in ivstyle option of xtabond2.

4. The robustness results with regard to Lewbel (2012, 2018) 2SLS method are not reported in the paper; however, they are available from the corresponding author upon request.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Moses Nyangu

Moses Nyangu is a PhD candidate in Development Finance at University of Stellenbosch Business School, in South Africa. He holds a Master of Commerce (Finance specialization) from Strathmore University and a Bachelor of Economics from Maseno University in Kenya. Moses’s research interest lies in the area of financial institutions and markets with application of Data Envelopment Analysis (DEA) and Stochastic Frontier Analysis (SFA) on measurement of efficiency and productivity analysis. His current research investigates various issues in the East African Banking Sector including bank efficiency, concentration, competition and bank risk-taking behavior.

Nyankomo Marwa

Nyankomo Marwa is a senior lecturer in Development Finance and Econometrics at University of Stellenbosch Business School, South Africa. Also, Nyankomo holds visiting positions at the School of Management Sciences of the University of Quebec Montreal, DR J Herbert Smith Centre for Technology Management and Entrepreneurship at the University of New Brunswick in Canada. He has published research articles in international peer-reviewed journals in the areas of development finance, efficiency analysis, applied econometrics and agricultural economics. He holds PhD in Development Finance from University of Stellenbosch Business School and MSc Agricultural Economics from University of Nebraska, Lincoln, USA.

Ashenafi Fanta

Ashenafi Fanta is a senior lecturer of development finance at the University of Stellenbosch Business School. Previously, he worked as Data Analysis and Segmentation Expert at FinMark Trust where he was involved in developing segmentation models, developed a new financial indicator, provided advise on how the FinScope methodology can be improved or enhanced by comparing FinScope survey against Global Findex and other demand surveys. Dr Fanta’s research publications are in financial development, financial inclusion and corporate governance of financial institutions. He holds a doctoral degree in Social and Economic Sciences: Corporate Finance, from Johannes Kepler University of Linz, Austria.

Elinami J. Minja

Elinami J. Minja is a Senior Lecturer in Finance and Economics at the University of Dar es Salaam Business School. He holds a Ph.D. in Economics from Oklahoma State University – USA; a Masters of Business Administration (MBA) from /investments and corporate finance. With more than 20 years of experience in academics, he has done a number of researches, consultancies and published in his areas of specialty University of Nairobi, Kenya and a Bachelor of Commerce (Accounting) from University of Dar es Salaam, Tanzania. Dr. Minja’s special expertise and strengths are in financial markets and actively participates in conferences and workshops.