Banking Sector Reform, Competition, and Bank Stability: An Empirical Analysis of Transition Countries

ABSTRACT

This study tests the impact of banking sector reform and competition on bank stability based on unbalanced data from 22 transition countries from 1998 to 2016. The initial results not only highlight the positive relationship between market power and bank fragility but also confirm the positive relationship between bank reform and stability. Our findings also show that both higher activity restrictions and more explicit guidelines for asset diversification increase bank stability, but this positive effect significantly weakens for banks with higher market power. More stringent capital requirements in combination with higher market power increase the risk of bank insolvency.

KEY WORDS:

• banking sector reform
• bank stability
• competition
• regulation
• transition countries

Acknowledgments

The author would like to thank the editor Ali Kutan and three anonymous referees for their valuable comments and suggestions.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 For the bank regulation and supervision information provided by Barth, Caprio, and Levine (2013), however, the surveys were conducted in 1999, 2002, 2006, and 2011. Following the study of Anginer, Demirguc-Kunt, and Zhu (2014a), we employ the previous survey data until the new survey data become available for matching the bank regulation and supervision variables with the bank-specific variables and country control variables: the survey data found in 1999 for 1998 to 2001, the survey data found in 2002 for 2002 to 2005, the survey data found in 2006 for 2006 to 2010, and the survey data found in 2011 for 2011 to 2016.

2 Focusing only on European cooperative banks between 2006 and 2014, Clark, Mare, and Radić (2018) study the relationship between competition and financial stability and show that a hump-shaped relationship exists between market power and stability.

3 Mare, Moreira, and Rossi (2017) also summarize the methods for computing the Z-score and outline some important limitations.

4 We define the output price $P_{it}$ as the ratio of total revenue to total assets following Angelini and Cetorelli (2003), Koetter, Kolari, and Spierdijk (2012), and Fu, Lin, and Molyneux (2014).

5 Bikker, Shaffer, and Spierdijk (2012) indicate that a scaled revenue function leads to a significant upward bias and incorrectly measures the degree of competition. Hence, in our analysis, we employ the unscaled revenue equation to reduce estimation bias.

6 The control variables include the following: Customer Loan, defined as the ratio of customer loans to total assets, to control for credit risk; NEA, defined as the ratio of other non-earning assets to total assets, to control for the composition of the asset; Customer Deposit, defined as the ratio of customer deposits to the sum of customer deposits and short-term funding, to measure the funding structure of the bank; and Equity Ratio, defined as the equity to total assets ratio, to account for leverage.

7 To deal with the potential heteroskedasticity problem, we estimate the unscaled PR revenue model in equation (5) by using pooled feasible generalized least squares, and clustered standard errors are also used to account for general heteroskedasticity and cross-sectional correlation in the model errors (Arellano 1987). We also follow the analysis of Bikker, Shaffer, and Spierdijk (2012) and employ an equilibrium ROE test to confirm whether banks operate in a long-run equilibrium. By using ROE as the dependent variable in equation (5), the H-statistic under the ROE test equals zero if the banking system operates in a long-run equilibrium.

8 We also include Foreign bank limitation, which measures whether foreign banks own domestic banks and may enter a country’s banking industry (lower values indicate greater stringency), and Entry barriers, which indicates whether various types of legal submissions are required to obtain a banking license (higher values indicate greater stringency). However, the results show no significant impact on bank stability.

9 Yeyati and Micco (2007) find a positive link between bank risk (as measured by the Z-score) and competition (as captured by the H-statistic) based on a sample of commercial banks from eight Latin American countries between 1993 and 2002. Schaeck, Cihak, and Wolfe (2009) use the data from 31 systemic banking crises in 45 countries in 1980–2005 and find that competition reduces the likelihood of a crisis. Anginer, Demirguc-Kunt, and Zhu (2014a) use a sample of publicly traded banks from 63 countries between 1997 and 2009 and find a positive relationship between competition and systemic stability.

10 For brevity, we only report the results for the FE estimations. The results for the IV estimations are consistent with those findings and are available upon request.

11 Previous studies such as De Haas and Van Lelyveld (2006), Havrylchyk and Jurzyk (2011), and Fang, Hasan, and Marton (2014) argue that foreign banks are not significantly sensitive to the bank reforms in host countries but are more sensitive to the wishes of parent banks in home countries and that foreign banks’ lending criteria are highly associated with the parent country’s regulation rather than that of the host country (Ongena, Popov, and Udell 2013). These conclusions may explain our findings: foreign banks are not sensitive to bank reform and changes in competitive conditions in host countries, as well as the relationships among bank reform, competition, and stability do not vary significantly for domestic banks or foreign banks.

12 During our sample period, some transition countries joined the EU including the Czech Republic, Hungary, Poland, Slovakia, and Slovenia (in 2004), Bulgaria and Romania (in 2007), and Croatia (in 2013). The banks in transition countries that joined the EU are subject to changes in the macroeconomic environment, financial markets, and bank regulation.

13 We are also concerned about how the bank reform changes affect bank stability. As a robustness check, we use the change in the bank reform indicator as an alternative measure of bank reform. The results are consistent with our main findings and are available upon request.

Additional information

Funding

This work was supported by the financial supports of the Fundamental Research Funds for the Central Universities: (Grant number 2242019K40158); National Natural Science Foundation of China: (Grant numbers 71673043, 71801040); National Social Science Foundation of China: (Grant number 18VSJ035).