COMPETITION AND STABILITY

IN BANKING SECTOR
Ctlin Emilian HUIDUMAC PETRESCU, Alina POP

Abstract. Similar to other economic sectors, competition in the banking

sector is often seen as a prerequisite for an effective banking system.
However theoretical and empirical studies have not reached conclusive
results on the positive relationship between competition among banks and
financial stability. There are analyzes that suggest that excessive
competition can lead to fragility and that regulations on competition are
necessary in order to ensure and maintain financial stability. This paper
examines competition and financial stability in the banking sector using
existing data on some banking institutions in Romania.
Keywords: financial stability, competition, Z-score.
JEL Classification: G21, D40.

1. Introduction
The concerns about banking sector stability and competition have
been accentuated by the emergence of the economic crisis. Between 1980s
until the mid-2000s the banking sector went through a process of
deregulation which allowed the beginning of an intense process of
innovation in this field. This process supported by a prolonged period of
relative economic stability, known in economics as the "Great Moderation",
has diversified banking activities creating new and highly complex
products and allowing banks to take excessive risks in order to increase
their profits. "The irrational exuberance" 1 which was generated by the
unprecedented stability caused excessive accumulation of debt which could

The Bucharest University of Economic Studies, Virgil Madgearu Building, Calea
Dorobanilor Street, no. 15-17, Bucharest 010522, Romania, email: catalinhuidumac
@yahoo.com.

The Bucharest University of Economic Studies, Virgil Madgearu Building, Calea
Dorobanilor Street, no. 15-17, Bucharest 010522, Romania, email: alina_aserom
@yahoo.com.
1
Groundless investor enthusiasm that determine an unsustainable growth in asset
prices. Allan Greenspan first used this term in 1996 in his speech "The Challenge of Central
Banking in a Democratic Society".

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no longer be paid. The mix innovation deregulation proved to be
ineffective as the banking sector was strongly affected by the economic
crisis starting with 2008.
The solutions adopted to overcome the crisis, which included among
others offering a form of financial support to the banks, saving the banks
through mergers or takeovers and also the nationalization of some of them,
will require increased attention from the competition authorities in the near
future. Moreover, the crisis has reiterated some of the previous beliefs
regarding the effects of competition in banking sector. Thus, the opponents
of bank competition presented arguments showing that competition was
partially to blame for the crisis. The first argument in this respect shows
that competition can lead to risky lending practices as financial institutions
seek to gain higher profit margins (the increase in subprime lending is seen
as an example of such behavior). The second argument used shows that
increasing competition may erode banks profit margins leaving them with
insufficient capital cushions (the insufficient capital cushions have also
played an important role in the recent crisis) (Peira and Love, 2012). All
these overlapped the deregulation process.
In the a paper called Booms and Lending Standards work Credit:
Evidence from the Subprime Mortgage Market, Dell'Ariccia, Gypsies, and
Laeven (2008) show that credit expansion, in the United States, prior to the
crisis, was due to a relaxation in the lending standards. This relaxation is
associated with a change in the market structure; as more companies
entered the market the rates of refusal of the existing creditors were
starting to follow a downward trend. Thus, the increasing competition
favored the access to lending to a special category of borrowers called by
Minsky, speculative and Ponzi borrowers. In an analysis of the Spanish
banking sector, Jimnez Lopez and Saurina (2007) show that between the
market power, measured by the Lerner index, and the financial risks there
is a negative relationship; as market power increases the non-performing
loan ratio decreases.
On the other hand, advocates of competition in the banking sector
show that the access to finance can be improved through competition,
particularly for small and medium size enterprises. At the same time, they
claim that any negative effects of competition on stability are best
addressed through appropriate regulation and supervision of the financial
institutions. In a research called How Bank Competition Affects Firms
Access to Finance conducted by Peria and Love (2012), on a total of 53
countries, including Romania, it was analyzed the relationship between
competition and firms access to finance. The research results show that

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overall low competition is associated with a reduced access to finance. The
research also took into account the characteristics of the environment in
which the banks were operating and its implications for competition and
access to finance. Thus it is found that countries with higher levels of
financial development and better information availability experience a less
pronounced decline in terms of access to finance as a result of low levels of
competition. In addition, significant government ownership of banks
exacerbates the damaging impact of low bank competition. On the other
hand the results show that low competition is more detrimental for firms
operating in countries with low levels financial development or lacking
credit information.
The literature presents a variety of such studies that analyze the
relationship between competition and stability, but the results are
inconsistent. Some of these indicate a positive impact of competition on
stability while others indicate a negative impact. Beck, De Jonghe and
Schepens (2011) analyzes the causes that lead to different results regarding
the relationship between competition and stability from one country to
another. The research starts with the assumption that the relationship
competition stability is influenced by a number of country specific
factors. Therefore, they took into account three key factors, namely, market
structure, regulatory framework and institutional framework. The research
results showed that an increase in competition is more harmful for stability
in countries with stricter regulations on banking activity, with a more
homogeneous market structure, with more effective systems of credit
information sharing, with a more generous deposit insurance systems etc.
The research also included an analysis of the changes that occurred in the
banking sector after some crisis episodes, when most countries either
extended their systems of deposit insurance (this is the case of the 2008
crisis), or imposed tighter restrictions on banking activities (the case of the
1930 economic crisis), and it was revealed the in this periods competition
had a very negative impact on stability. Also, in terms of capital buffers the
results show that imposing stricter capital regulation can have an
exacerbating influence on the relationship between competition and
stability. Regarding the institutional framework, the research took into
account the arrangements made to reduce moral hazard and asymmetric
information, such as for example the credit bureaus in Romania. The
checks carried out by these institutions lead to a decrease in credit risk and
indicate a positive relationship between market power and stability.

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 2. Measuring financial stability and competition
To test the relationship between competition and stability in the
banking sector, it is necessary to establish an appropriate way of measuring
both. Financial stability is most often analyzed in terms of individual or
systemic imbalances that affect banks. Systemic banking difficulties are
defined broadly as the period during which the banking system cannot
effectively exercise its role (Beck, 2008, p. 4).
To distinguish between fragility in general and crisis in particular and
between local and systemic crises, Demirguc-Kunt and Detragiache (2005)
consider that an episode of imbalances can be classified as a crisis if it meets
one of the following conditions (i) non-performing assets represents at least
10% of total assets at the peak of the crisis, (ii) tax costs on aid to banks is at
least 2% of GDP, (iii) emergency measures, such as freezing, or
guaranteeing the consumer deposits or other similar measures were taken to
support the banking system, or (iv) banking problems have led to a
widespread nationalization of banks. Laeven and Valencia (2012) define a
crisis as systemic if two conditions are met (i) there are clear signs of
financial difficulties in the banking system (e.g. massive withdrawals),
(ii) there were adopted significant intervention measures as a response to
substantial losses recorded in the banking system. Intervention measures are
considered by the two authors as significant if at least three of the following
six measures were used: 1) extended liquidity support 5 percent of
deposits and liabilities to non-residents; 2) gross cost of bank restructuring
is at least 3 percent of GDP; 3) significant nationalization of banks; 4) the
adoption of significant guarantees; 5) acquisition of assets at least 5
percent of GDP; 6) freezing deposits and / or prolonged bank holidays2.
Financial stability is best illustrated in its absence during periods of
financial instability. However, the definition of stability must be extended,
highlighting the positive aspects arising from ensuring a stable financial
system. Thus, according to the World Bank a stable financial system
means a system capable to (i) efficiently allocate resources, (ii) evaluate
and manage financial risks, (iii) maintain employment rates in the
economy close to the natural rate of employment, (iv) eliminate the relative
price movements of financial or real assets etc.

2
Normally bank holidays coincide with national holidays and refer to situations during
which banks are closed for business to the public. In situations of financial imbalances, bank
holidays can also refer to situations where is an emergency bank closure averting a bank run.
This type of bank holidays occurred during the Great Depression in the United States due to
the Emergency Banking Act of 1933.

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 A measure used for assessing stability of individual institutions is the
Z score. It measures a bank's solvency risk by comparing buffer with risks.
The widespread use of this indicator stems from its ability to highlight the
probability of default of a financial institution, i.e., the probability that the
value of its assets becoming less than the value of its debt. As the value
obtained for the Z score is higher, the probability of insolvency of a bank is
lower. World Bank (2013) highlights the limitations of this indicator most
of them arising from the information needed to calculate it. The data used
to calculate the Z score are data from the accounting registrations of the
banks, therefore the validity of the results will depend on the accuracy of
the accounting information. At the same time, the Z score analyzes each
institution separately without considering potential losses suffered by other
institutions in case of risks manifested to a particular bank.
Another approach for measuring banks stability is Merton model. The
model was developed in the 1970s and it determines the ability of an
institution to meet its financial obligations and measures the overall
probability of default. The model defines the overall probability of default
as the situation where the value of a bank liabilities exceeding its assets
(World Bank, 2013).
Unlike financial stability, competition it is even more difficult to
measure. There are currently several methods used to measure the level of
competition in the banking sector. According to Bikker and Spierdijk
(2009) competition in the financial markets should be strong enough to
support the welfare and economic development, but at the same time it
should not be too high so as to threaten financial stability, innovation and
the access to finance. To achieve this goal an optimum level of competition
in the banking sector should be estimated. In order to do that some key
elements should be taken into consideration, including market structure,
regulatory framework and the financial level of development of the
countries. Competition in the banking sector was generally analyzed in
terms of market power or in terms of efficiency. Market power reflects the
ability of some banks to control the market while efficiency refers to the
ability of some banks to obtain products at minimum cost. The competition
measurement methods were also classified based on other factors, such as
market structure, competitive behavior of banks and indicator of regulatory
framework.
A first measure of competition is Herfindahl-Hirschman index (HHI)
which measures the degree of market concentration. This indicator is often
used in the context of the paradigm "Structure-Behavior-Performance"

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(SCP) which assumes that market structure affects the behavior of banks
on the market and therefore their performance. A banking sector in which
several banks have a significant market share can lead to a form of
behavior that is likely to distort competition (e.g.: agreements between
banks), which will ultimately affect banks' performance (excessive profits
gains). This could lead to higher prices than in normal competition
situations, generating a negative effect on consumers. Another competition
measurement method developed by Panzar and Rose is H-Statistics. This
indicator measures the competitive behavior of banks. Similar to this
indicator, the Lerner index is often used to determine the level of
competition in the market. It measures market power using the marginal
cost and the price. The value obtained for the Lerner index will be between
0 and 1. A value close to 0 indicates a competitive market, while a value
close to 1 indicates a monopoly.
An alternative and relatively new method for measuring competition,
different from other measures, which analyses the competition in terms of
efficiency, is the "Boone" indicator. This indicator measures the effect of
efficiency on the performance of the bank in terms of profit and market
share. The Boone indicator is based on the assumption that competition
enhances the performance of the more efficient banks (those recording a
lower marginal cost) and impairs the performance of inefficient banks,
which is further reflected in lower profits or smaller market shares
(Leuvensteijn et. al. 2007, p. 5).
The regulatory framework may also offer some indications of the
competition in this sector. The conditions for authorization of banks which
refer to ownership structure, capital level, business plans, qualifications
and professional experience of bank managers and other elements required
by law, constitutes a legal but necessary barrier to entry for new
institutions. The presence of other forms of restrictions such as the
existence of formal and informal barriers to entry the market, restrictions
on banking activities or others as such, could prevent new banks from
entering the market therefore restricting competition.

3. Competition and stability in Romania

The Romanian banking system counts 40 credit institutions, of which 31
are Romanian legal entities and 9 foreign bank branches. In terms of market
shares the banks with majority foreign capital dominate the Romanian
banking sector, with approximately 80% market share. The 9 foreign bank
branches, although they hold a relatively small market share, about 10%, they
helped to increase competition in the domestic banking sector.

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 Because of the difficulty in obtaining the necessary data, the analysis
will focus on the top five credit institutions, based on their market share,
operating in the Romanian banking sector respectively, Romanian
Commercial Bank, BRD - Groupe Socit Gnrale, Transilvania Bank,
UniCredit Tiriac Bank and Raiffeisen Bank. These institutions held in
2014, 54.2% of the total market share (Figure 1).

Figure 1. Market share distribution for top 5 banks in 2014.

Source: National Bank of Romania.

The data used in the analysis were obtained from the existing
financial reports published on the banks websites. The data include annual
information included in the banks balance sheets and covers the period
2009-2014.
To measure financial stability it was used the Z-score. When
computing the Z-score a rolling average of two years of the data was used.
The Z-score was estimated as follows:
ROAit + EQTAit
Z it =
itROA
where:
ROAit represents the two year average return on assets for bank i at
time t;
EQTAit represents the two year average of capital over assets for
bank i at time t;
itROA represents the standard deviation for return on assets for a
period of two years for bank i at time t.

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 The Z-score increases when the level of return on assets and
capitalization increases and decreases when there is volatility in the level
of returns. Therefore, a higher value of the Z-score indicates a more
stable bank.
Table 1
Descriptive statistics for Z-score.

Z-score ROA EQTA

Mean Median Mean Median Mean Median

Romania
Commercial 6,450 6,282 0,006 0,00 0,096 0,096
Bank
BRD Groupe
8,805 8,687 0,007 0,001 0,114 0,116
Societe Generale
Transilvania
55,831 54,104 0,009 0,010 0,095 0,095
Bank
UniCredit iriac
24,379 24,621 0,007 0,007 0,107 0,109
Bank
Raiffeisen Bank 132,773 134,926 0,017 0,017 0,113 0,114

Source: own calculation.

The values obtained for the Z-score vary significantly from one bank
to another. Comparing the results it appears that Raiffeisen Bank recorded
the highest average value for this indicator 132.7, while the Romanian
Commercial Bank has obtained the lowest average value (Table 1). Overall
the data indicate on the one hand that Raiffeisen Bank and Transilvania
Bank are the most stable banks in the sample, and on the other hand that
the Romanian Commercial Bank and BRD Groupe Socit Gnrale are
relatively more risky. These differences arise mainly from changes
observed in the level of the return on assets and less due to changes in the
level of equity to total assets. An analysis of the causes that led to a low
level of return on assets is needed in order to improve the results for the
stability indicator of the banking institutions.
In terms of determining the level of competition in the Romanian
banking sector it was used as a measure of competition the Herfindahl-
Hirschman Index (HHI). HHI index was estimated as follows:
n
HHI = si2
i =1

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where:
s represents the market share for bank i;
n represents the number of banks operating on the market.
In order to compute the HHI index we used information available in
the National Bank of Romania annual report for 2014. The value obtained
for HHI is 868.56 points which indicates a competitive to moderate
banking sector.
Regarding the market shares it can be notice a concentration of the
market power to the first five banks in the banking system. The first two
banks maintained their positions in the last 5 years, i.e. from 2009 to 2014,
although there is a slight decrease in market share, from 19.1% in 2009 to
16.2% in 2014 for the Romanian Commercial Bank respectively, from
14% in 2009 to 12.4% in 2014 for the BRD Groupe Socit Gnrale. On
the other hand, the banks from 3rd to 5th position registered increases in the
market share, the most significant growth being recorded by Transilvania
Bank, 0.9 percentage points in 2014 compared to 2013.
Comparing the data on stability and the data on competition it can be
notice that banks with greater market power recorded lower values for the
Z-score. However, there are other factors that need to be taken into
consideration when assessing stability. For example, a large number of
loans granted by the bank proved to be non-performing. The Romanian
Commercial Bank recorded the 3rd highest non-performing loan ratio at
the end of 2014. Therefore, an improvement in the return on assets, for
example, or imposing more stringent credit standards could improve the
results on stability.
4. Conclusions
The literature presents an increasing number of studies that analyze
the relationship between competition and stability due to the effects that
the economic crisis has had on the banking system. Economic imbalances
caused changes in the structure of the financial markets leading toward a
more concentrated financial sector. The implications that these changes
have on the banking activities and on the consumer must be identified on
time in order to manage any risks arising therefrom.
Regarding the Romanian banking sector, the economic crisis has not
led to significant changes in its structure. The banking sector remains a
competitive one, recording even a slight decrease in the market share for
the top banks.
Also, the Romanian banking system has proved to be quite stable
during the crisis. However the presence of foreign banking institutions in

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the market and the dominance of the banks with majority foreign capital
require a high caution in this area.
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