DEBRE MARKOS UNIVERSITY

FACULTY OF BUSINESS AND ECONOMICS

MSC IN ACCOUNTING & FINANCE PROGRAM

The effect of bank competition on Financial Stability (Case of selected commercial Banks in
Ethiopia)
By Mikias Degwale

A Research paper Submitted to the Department of Accounting and Finance in Partial Fulfillment
of the Requirements for the Award of Masters of Science Degree in Accounting and Finance

Advisor:

Degu Kefale (Assistant Professor)

December, 2021

Debre-Markos, Ethiopia
Abstract
This research proposal intends to the effect of Bank competition on Banks Financial stability in
the selected commercial banks in Ethiopia. In addition it investigates the major challenges of
bank competition that directly affect Banks financial stability. Based on the literature that the
researcher used liquidity, operational efficiency, asset quality, capital adequacy, profitability
are addressed using different theories and models that can be used to measure competition as
independent variables and Stability which is dependent variable.
The study adopts both Qualitative and quantitative research design. Data will be gathered
through already prepared annual financial statements of the selected commercial Banks in
Ethiopia. The samples were selected from 17 commercial Banks in Ethiopia by judgmental or
convenience sampling technique.
To test the relation between the selected variables Multiple Linear Regression method was used.
The empirical result shows that liquidity, operational efficiency, asset quality, capital adequacy,
profitability has both positive and negative effect on commercial banks financial stability.
Therefore Commercial Banks in Ethiopia need to satisfy these dimensions
Key words: Commercial Banks, Financial Stability, Competition
 CHAPTER ONE
1.1. BACKGROUND OF THE STUDY
Banks play a key role in improving economic efficiency by channeling funds from resource
surplus unit to those with better productive investment opportunities. Banks also play key role in
trade and payment system by significantly reducing transaction costs and increasing convenience
(NCA, 2006). In less monetized countries, like Ethiopia, whilst financial sector is dominated by
banking industry, effective and efficient functioning of the latter has significant role in
accelerating economic growth. To enhance the role of banks in an economy, competition is an
important driving force; without competition, it is improbable to bring about efficiency and
foster financial sector development. In other words, insufficient competition may result in
substantial social losses on account of higher price, higher transaction cost, lower credit supply,
lack of innovation and poor service quality. Although competition has a positive effect on
efficiency and economic growth, there are certain characteristics that may indicate restrictions on
banking. In the absence of proper information processing (where the problem is eminent in less
developed economies), banking industry is more vulnerable to instability relative to other
industries, owing to the existence of short term liability versus long term assets and the presence
of highly leveraged firms and banks that have an incentive to engage in risky behavior
(Northcott, 2004).
Intensive competition may lead to excessive risk taking by banks, which would result in
deterioration of the quality of banks’ lending portfolio and balance sheets. If banks suffer
deterioration in their balance sheets and so have a substantial contraction in their capital, they
will have fewer resources to lend, hence a decline in investment spending, and slower economic
activity. If the deterioration in bank balance sheets is severe enough, banks will start to fail, and
fear can spread from one bank to another. Depositors, fearing for the safety of their deposits and
not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that
multiple bank failures occur, whose ultimate consequence would be severe contraction in
economic activity. This suggests the need for some degree of market power in achieving stability
and efficient allocation of resources in banking industry (Padoda, 2000).
From both theoretical and pragmatic point of view, it is very difficult to generalize about the
right magnitude of competition in the banking industry, for it is likely to be more specific to a
particular country in a particular time, and the methodology adopted. By and large, it all depends
on country specific parameters including level of economic development, development of
financial markets, legal frameworks, political platform, and the availability of foreign financial
institutions. Thus, the notion of “one size fits for all” is not to do with banking competition,
making it one of the most indistinct economic areas.
1.2. Banking Competition Environment in Ethiopia
Modern banking in Ethiopia started in 1905 with the establishment of Bank of Abyssinia, which
was based on a fifty year franchise given to the British-owned National Bank of Egypt. It has
landmark significance in introducing financial services, which were hitherto unknown in the
country (Alemayehu, 2006). A significance feature of commercial banking in Ethiopia then was
its innovative nature rather than its contribution to growth and its competitive nature. As the
society was new for the banking service, banks had faced difficulty in familiarizing the public
and they faced considerable cost of installation.
In the pre-1974 era, there hardly was any banking competitive environment, as the banking
industry was dominated largely by a single government owned bank, State Bank of Ethiopia.
Despite the efforts made to disengage banking from foreign control and to make the institution
responsible to Ethiopia’s credit needs, these developments did not bring about meaningful
competitive environment, as banking industry was characterized by specialization and low level
of business. The establishment of privately owned Addis Ababa Bank in 1964 and its growing
branch network created relatively better banking competition among commercial banks, with
concentration of their branch offices in big towns and trade routes in the country. The then
monetary and banking system gave at most emphasis to stability and balanced growth of the
economy rather than competition (proclamation No.206/1963). Competition during the period
was generally weak. During the Derge regime, there was one commercial bank, whose
overriding objective was to accelerate development so as to improve the standard of living of the
broad masses rather than maximization of profit. Thus, competition among banks was not taking
place during this regime as it was characterized as command economy, instead of market
oriented.
The change of government in 1991 and the consequent changes in economic policy witnessed
another transformation in the banking industry. Monetary and Banking Proclamation of 1994
established the National
Bank of Ethiopia as a judicial entity separated from the government and outlined its main
functions. Monetary and Banking proclamation No.83/1994 and the Licensing and Supervision
of Banking Business No.84/1994 laid down the legal basis for participation of the private sector
in banking business, which had been completely prohibited during the Derge regime. Shortly, the
first privately owned commercial bank, Awash International Bank, was established in 1994.
Afterwards, additional seven privately owned banks have been established. The government’s
strategy for financial development was characterized by gradualism and maintaining
macroeconomic stability (Addison and Alemayehu, 2001).
As there is no single and confined way of analyzing the status of competition, the factors
determining competitive environment are multi-faceted and complex. Accordingly, various
indicators (both qualitative and quantitative) are used to catch sight of the facts from different
angles.
Competition in the Ethiopian banking industry is basically explained by competition between
commercial banks and hence in most of the discussion that follows, comparisons are made
among commercial banks.
The impact of bank competition on financial stability has been widely discussed in the academic
and political communities over the last two decades and particularly since the 2007 to 2008
global financial crisis (Clark et al., 2018; Fuet al., 2014). During the decades of the 70s and 80s
in the last century, there was an intensification of financial deregulation that promoted the
globalization of financial markets and the financial innovation, which in turn led banks to adopt
much more aggressive policies, increasing the degree of competition (Cuestas et al., 2020;
Danisman & Demirel, 2019). For many, this excessive risk-taking behavior by the banks was the
key to the 2007 to 2009 crisis. This has led in Europe, as in the worldwide, in the past few years,
a strengthening of prudential regulation via increased capital requirements and other obligations
that incorporate aspects that can affect competition in the banking sector. Also, there was a
reduction in the number of banks operating in most countries, with the troubled banks being
bailed out by national governments or absorbed by other banks. These two phenomena may have
modified the competitive conditions in which banks operate, re-launching the discussion about
the relationship between competition in the banking sector and its financial stability in the
scientific community.
While it is agreed at an academic level that greater competition in the banking sector leads to
greater innovation and efficiency (Schaeck & Čihák, 2010; Turk Ariss, 2010), there is still no
consensus as to whether the impact of competition on the banking sector will lead to greater or
lesser financial stability. The traditional banking literature supports a “competition-fragility”
nexus. Under this hypothesis, bank competition will lower the net interest margin, eroding
bank’s profits, which will lead to an increased probability of bankruptcy, and consequently, the
overall disruption of the financial system (Allen & Gale, 2004; Keeley, 1990; Marcus, 1984).
More recently, Boyd and De Nicoló (BDN; 2005)
 1.3. STATEMENT OF THE PROBLEM
In Ethiopian context, one cannot confidently argue that there has been rigorous banking
competition. During the pre-1975 imperial era, there had few banks (dominated by foreign
ownership) and the absorptive capacity of the economy was too low even to accommodate
moderate competition. In the Derge regime (1975-1991), private banks were fully nationalized
and left no room for competition. After the down fall of the Derge regime in 1991, private banks
were again allowed to operate consistent with the ideology of market oriented economic policy
(Alemayehu, 1986). Accordingly, new private banks were established and their role and position
in the industry have been flourished from time to time.
Although this topic has already been investigated in the European, and some African countries
context, this research is of particular interest because it analyzes a sector in constant change and
which is essential for the good functioning of the economy.
This reason justifies my work, which presents the following distinctive aspects from those
previously carried out in Leroy and Lucotte (2017). First, I emphasize the fact that the
relationship between bank competition and financial stability can be differentiated depending on
whether the bank operates in a more or less stable banking system. Second, to measure the bank
competitiveness, I was considered a new market measure, computed with market data, and not
obtained from data provider services. Finally, to account for the persistence in the relationship
between banking competition and financial stability, I considered a dynamic panel data model,
instead of the traditional static model, estimated by a method that allows us to obtain more
efficient estimators.
The researcher tried to assess the relationship between bank competition and financial stability of
Commercial banks in Ethiopia by raising the following research questions as follows,

1. Is there is commercial Banking competition in Ethiopia?

2. What the effect of bank Competition on the Stability of selected commercial banks in
Ethiopia?
3. How does bank competition affect financial stability?
1.4. OBJECTIVES OF THE STUDY
1.4.1. GENERAL OBJECTIVE

The main objective of the study is to assess the trend, nature, and extent of competition in the
Ethiopian banking industry and provide suggestions as to how optimal banking competitive
environment is achieved given the existing reality in the country and its effect on financial
stability on commercial banks.
1.4.2. SPECIFIC OBJECTIVES OF THE STUDY
 To investigate whether there is Banking competition among commercial banks in
Ethiopia or not.
 To examine the effect of bank Competition on the Stability of selected commercial
banks in Ethiopia
 To assess how bank competition affect financial stability of selected commercial banks
1.5. SCOPE OF THE STUDY

The study is confined to assess the effect of bank competition on bank financial stability of
selected commercial banks in Ethiopia. For the sake of uniformity and due to their more
involvement in retail banking, only data that was obtained from commercial banks was used in
this study. Other bank with development objective like Development Bank of Ethiopia was not
get attention in this study. Moreover, the study focuses from the year 2016 up to 2021 for 6 years
banks financial performance and development trends.
1.6. LIMITATION OF THE STUDY

The focus of this study was examining the effect of bank competition on banks financial stability
of selected commercial banks in Ethiopia. In the subject matter, it was very difficult to get
secondary data as well as literature in this area from the country perspective. In addition time and
financial constraints was also became the main limitation of the study.
1.7. SIGNIFICANCE OF THE STUDY

Since competition in banking sector is becoming strong in Ethiopia, by investigating the impact
of Competition on financial stability of commercial banks and by recommending solutions for
the identified problems, this study will help banks to benefit from the result. In addition, it helps
to fill significant knowledge gaps about competition and financial stability by commercial banks
in Ethiopia; thereby it will give insight to researchers and students about the problem and
stimulate further investigation of the issue.
1.8. ORGANIZATION OF THE PAPER

This paper consists of five chapters with different sections and sub-sections. Chapter one
presents the introduction for the main part of the paper, and chapter two states the theoretical and
empirical literature review about the Competition and financial stability of banks in some
countries supported by different theories. Chapter three discusses research methodology. Chapter
four focuses on results and discussions. Finally, the last chapter (chapter five) gives conclusion
and recommendation of the study.
 CHAPTER TWO

2. LITERATURE REVIEW
2.1. Theoretical Background
2.1.1. Schools of thought on bank competition
Schools of thought on bank competition
Most scholars have been discussing the relationship between banking rivalry and financial
stability for the last two decades. Most of these discussions went viral especially after global
financial crisis of 2007. Therefore, competition in banking sector has been one the most debated
issues of all time. Previous literature by Koetter et al, (2012) provides evidence that there are two
mostly argued theories regarding banking competition and its stability. The first theory is known
as competition fragility theory. This theory states the negative correlation between banking
competition and its stability. This can be explained by the fact that too intense rivalry among
banks has negative influence on market power and margins of profit. This, in turn, leads banks to
make risky decisions. Another school of thought of banking literature suggests competition
stability theory which emphasizes greater banking stability as the result of increased competition
among banks. The explanation for this theory can be provided in terms of interest rates which
decrease as a result of increasing competition. As a result of reduced moral hazard and adverse
selection problems, banks start to issue more loans by decreasing default rates of loans which
ensures the stability of banks Koetter et al, (2012).
The study conducted by Kasman, Saadet, and Adnan Kasman (2015), analyzed the influence of
banking competition on Turkish banking sector during the period of 2002-2012. In order to
measure the competitiveness of banks, Boone indicator and Lerner index were used. In order to
measure the stability, researchers used non-performing loan ratios and Z-score. Results of the
study showed negative correlation between bank competition and non-performing loan ratio.
However, positive link has been identified between bank competition and Z-score. The results of
this research provide support for bank-fragility theory. According to his theory, banks risk taking
incentives are influenced by increasing bank competition. It is explained in the case of perfect
competition where the profit of banks will be zero and investments opportunities offered by
banks will be reasonable for many clients since banks will not be afraid of losing anything
(Keeley, 1990). One more theory related to bank competition proposed by Keeley (1990) can be
used to explain the bank competitiveness theory. In other words, it is believed that less
concentrated banking markets are main culprits of financial crises. In this case, it is important to
mention the franchise value of banks. Franchise value controls the activities of the banks by
reducing the number of risk taking bank activities. Banks with high rates of risk taking is
believed to be involved in insolvency. Therefore, competition fragility theory mentions that as a
result of excess competition, franchise value of banks starts eroding leading banks to more risk
taking activities. In imperfect competition, the cases of bankruptcy can be eliminated in the
presence of high market power (Leon, 2015; Beck, 2013; Milbourn, 1999). Another famous
theory in the banking literature known as competition stability theory assumes positive link
between bank competition and stability. It is stated that less competition results in high interest
rates. High rates of interest can lead to moral hazard problem by increasing non-performing loan
ratio of banks. Most of the previous papers also considered the relationship between the banks
and borrowers. The research by Boyd and De Nicolo (2005) proposed the theoretical model
mentioning that borrowers are able to identify the riskiness of projects using the case of loan
rates. The study conducted by Boyd and De Nicole (2005) provides the support for competition-
stability theory. In other words, it implies that less competition in banking sector results in high
interest rates charged by banks. Therefore, it is supposed that less banking competition with high
interest rates can lead to the bankruptcy of the borrowing firm.

Definition of Competition
According to Philip Molyneux (2012), Competition can be defined as the state of rivalry among
suppliers of a product. Depend on the level of competition any industry/market is classified as
perfectly competitive, monopolistically competitive, oligopoly or monopoly.

The issue of competition in the banking sector has attracted much interest in recent years,
not least because of the recent financial crisis. Alongside the usual concerns about
competition, the issue has additional significance in banking because of its crucial role on
non-financial activity. Many theoretical papers have attempted to explain the ambiguous
consequences of competition on access to credit, cost and quality of financial services,
innovation, the stability of financial systems, and thus economic development. To
empirically address these important questions, one first needs to come up with reliable
measures of the intensity of bank competition. The more accurate the measure, the more
precise empirical results are likely to be.
The assessment of competition in the banking industry and its effect on financial stability has a
long tradition. The literature on the measurement of competition is generally categorized
into two major of streams. Based on traditional Industrial Organization, early research
focused on market structure-performance linkages (the Structure-Conduct-Performance
paradigm) which stated that the likelihood of collusion increases with market
concentration. Some authors, however, raised doubt about the reliability of the Structure-
Conduct-Performance paradigm and associated structural measures of competition. In
response to deficiencies found in the structural approach, non-structural measures of
competition have been developed. The aim of the New Empirical Industrial Organization
(NEIO) measures is to directly assess the competitive conduct of firms. The first
generation of non-structural measures is based on oligopoly theory and a static model of
competition. The Lerner index, the conjectural variation model and the Panzar-Rosse
model can all be attached to this conception of competition. Subsequently, other non-
structural measures, especially the Boone indicator, have been developed with the
objective of capturing the dynamic of the market rather than focusing on static analysis.
While some researchers may prefer one measure over another, there is no consensus
regarding the best measure by which to gauge competition. The different indicators of
ban- king market competition does not provide the same inferences about competition
(Carb´o-Valverde et al., 2009; Liu et al., 2013). Therefore, the choice of a particular
indicator influences conclusions regarding the assessment of bank competition and its
effect on financial stability. The choice of techniques involves tradeoffs. The usefulness of
the different approaches hinges on data availability, the conceptions of competition
assumed, and the questions being addressed. In this part of this paper the researcher is
going to present the most widely-applied methods in banking, highlighting their strengths
and weaknesses. It complements existing reviews written by Degryse et al. (2009) and Liu
et al. (2013).
2.1.2. TWO CONCEPTIONS OF COMPETITION

Although the concept of competition has always been central to economic thinking, it is
one that has taken on a number of interpretations and meanings. Conceptions of
competition originate in The Wealth of Nations (Smith, 1776). In the Smithian analysis,
free competition is an ordering force toward equilibrium. In the long run, free competition
leads to prices being equal to the costs of production. Nonetheless, for Smith, competition
is not a state or situation but a race between competitors to gain market share. It is rivalry
that forces price towards the equilibrium of supply and demand. An essential condition for
free competition is not the number of rivals (while it may help) but rather individual
freedom.
 A. Competition as a static state

Cournot (1838) was the first to relate free competition to the result of competition. Cournot
defined the ideal of competition, not as the process that in the long run tends toward a certain
equilibrium position, but rather as the equilibrium condition itself. Competition is a situation
where prices equal the costs of production (natural prices). To obtain a competitive situation,
there must be several assumptions (a considerable number of rivals, possessing common
knowledge about market opportunities, free entry and exit), which was never explicitly
mentioned by Smith with the exception of the number of rivals (Blaug, 2001). This latter
assumption plays a central role in Cournot’s analysis. Accor- ding to him, the excess of the price
of cost approaches zero as the number of producers increases. The analytical refinement was
extended by some economists, particularly Edgeworth, Jevons, Walras, Marshall, Clark, and
received its fullest expression in Knight’s book Risk, Uncertainty and Profit. Perfect competition
is the antithesis of monopoly. In monopoly, there is no one to compete and a monopolist could
extract abnormal profits, although limited by the elasticity of demand.
By 1883, Bertrand criticized Cournot’s oligopoly theory arguing that relevant strategies for firms
are prices and not quantities. As a result, the linkages between structure and conduct are less clear
than postulates of the Cournot model. A half century later, Cham- berlin (1933) and Robinson
(1933) wrote other important contributions to the oligopoly theory. They proposed reconciling
perfect competition and reality by developing a theory of workable competition. Much of the
business world is a mixture of competition and monopoly. Monopolistic competition is a type of
imperfect competition such that many producers sell products that are differentiated from one
another as goods but are not perfect substitutes. In monopolistic competition, a firm takes the
prices charged by its rivals as a given and ignores the impact of its own prices on the prices of
other firms.
Different critiques have been introduced in the static oligopoly theory that recognize different
possible forms of market structure (Vives, 2001). The oligopoly theory allows scholars to derive
testable hypotheses and therefore measure degree of competition. As a consequence, the
neoclassical conception of competition based on the oligopoly theory is at the root of both
structural and the majority of non-structural measures of competition (the Lerner index, the
conjectural variation model and the Panzar-Rosse model). The oligopoly theory distinguishes
between the different forms of market structure (perfect competition, imperfect competition and
monopoly). This conception of competition is, however, challenged by another view that focuses
on dynamic aspects of competitive rivalry.
 B. Competition as a process of rivalry

The Austrian School, led by von Mises, Schumpeter and Hayek, argue that economists in the
neoclassical tradition misuse the term competition by applying it to a state rather than to a
process. 5 Competition is viewed not as a static state but as a complex process of rivalry between
firms. The core of competition is the behavior of firms (and entrepreneurs) in the market. Firms
are engaged in a continuing dynamic competitive process, constantly creating and adopting new
products and processes in order to cope with competition. The competition process acts as a
selection mechanism through the destructive-creation principle: Less efficient incumbents are
removed and replaced by more efficient entrants. Stigler (1957) defines competition as “a rivalry
between individuals (or groups or nations), and it arises whenever two or more parties strive for
something that all cannot obtain”.
Vickers (1995) points out that this rivalry “encompasses all sorts of forms of rivalry (market
trading, auctions, races, wars of attrition, etc.), instruments of rivalry (prices, advertising, R&D,
takeover bids, effort levels, etc.), objects of rivalry (profits, market share, corporate control,
promotion, prices, survival, etc.), as well as types of rival”.
In the Austrian School’s perspective, a market is competitive when rivals are sufficiently
aggressive to give an incumbent incentive to improve (better quality, lower price, new services,
more innovation, improved management, etc.) in order to maintain its advantage. Inefficient firms
are directly sanctioned by consumers while more efficient and innovative companies are
rewarded.
The role of monopoly and market power is revisited in the Austrian School perspective. While
firms are unable to raise prices over marginal cost in a perfect competition framework, for the
Austrians the existence of rents is a normal aspect of the competitive process. In a free
competitive market, each firm innovates and develops risky strategies in order to gain a
competitive advantage over its rivals. Firms that do obtain such an edge temporarily derive static
monopoly power during the interval before imitating competitors replicate their innovation, or
supersede it with one that is superior. Successful firms earn temporary monopoly profits as their
reward for risky strategies. As a result, a free competitive market is compatible with market
power and” abnormal” profit rates.
The fact that the neoclassical conception of competition poses some clear testable hypotheses
explains that a majority of competition measures are rooted in this model. The structural approach
refers to the structure-performance relationship that exists in Cournot’s analysis. The first
generation of NEIO measures (the Lerner index, the conjectural variation model and the Panzar-
Rosse model) was built on this model. More recently, new non-structural measures which are in
many ways sympathetic to the Austrian conception of competition have been proposed, most
notably the Boone indicator.
2.2. EMPIRICAL LITERATURE REVIEW
The effect of bank competition on financial stability has been widely discussed in the theoretical
and empirical literature, though with conflicting views.
According to the competition fragility view, based on the charter value hypothesis (Keeley,
1990),an increase in the degree of competition may lead both to a decrease in lending rates and a
rise in deposit rates, with a consequent reduction in profit margins. This would also cause a
decrease in the franchise value of banks and incentivize more risk-taking, with a possibly
negative impact on the stability of the individual institutions and of the whole system. On the
contrary, according to the competition-stability view (Boyd and De Nicolò, 2005), a rise in the
degree of competition, by reducing the interest rates charged by banks, may imply better credit
conditions for borrowers. This would make it easier for them to repay bank loans, thereby
reducing the risk of the loan portfolio and improving the stability of individual institutions.
More recently, in order to reconcile the two opposite views, some papers have explored the
possibility of some nonlinear relationship (Martinez-Miera and Repullo, 2010). Also, some
theoretical work (Freixas and Ma, 2014) has been conducted on the impact of competition on
different aspects of financial stability. The paper considers various types of risk both at the
individual institution level and at the systemic level and examines the role of leverage in driving
the relationship in each case.
The existing empirical studies have provided different results and conclusions. Some studies
have analyzed the issue from a cross-country perspective, using large datasets of banks from
different countries (Liu, Molyneux and Wilson, 2013; Schaeck and Cihak, 2014; Beck, De
Jonghe, and Schepens, 2013; Berger, Klapper, and Turk-Ariss, 2009; Turk-Ariss, 2010). Other
analyses have examined the topic at the country level, using more granular datasets based on
supervisory data, to account also for the possible multiplicity of bank products (Jimenez, Lopez,
and Saurina, 2013;Kickand Prieto,2013).
In the empirical work, the researcher analyzed the effect of bank competition on financial
stability for the banks in the Ethiopian context. In particular, the researcher estimates the effect
of price competition on distinct sources of individual bank risk: solvency, liquidity, and credit
risk. In the following paragraphs, the researcher defines and describes also on the basis of the
existing literature the main hypotheses that aim to investigate for the competition stability nexus.
A. Solvency Risk
The solvency risk defines the risk that a bank cannot meet maturing obligations because it has a
negative net worth; that is; the value of its assets is smaller than the amount of its liabilities. This
may happen when a bank suffers some losses from its assets because of the write-offs on
securities, loans, or other bank activities, but then the capital base of the institution is not
sufficient to cover those losses. In such a case, the bank unable to meet its obligations defaults
and loses its franchise value. In order to avoid such risk, banks need to keep an adequate buffer
of capital, so that in case of losses, the bank can reduce capital accordingly and remain solvent.
On this reasoning, the researcher may consider the solvency position of a bank as determined
by two main factors: the availability of an appropriate buffer of capital and the profitability of
bank activities. The indicator of bank solvency generally used in the empirical analysis, the Z-
Score, reflects these two factors because it is computed as the sum of the equity-asset ratio
(bank capital) and the return on assets (bank profitability), divided by the standard deviation of
the return on assets (profit volatility). Then, in order to study the relationship between
competition and solvency and to formulate our hypotheses for the empirical analysis, we need
to investigate whether, and how, price competition may affect these two components of bank
solvency.
The researcher starts from the nexus between competition and profitability, which is less
subject to debate and interpretation. An increase in price competition (or a decrease in market
power) reduces the profit margins of a bank. This implies that banks with large market power
are also more profitable. So, if we consider profitability as a determinant of bank solvency, then
we can argue that competition may have a negative impact on profitability and so may reduce
solvency.
On the other hand, the researcher has to inquire whether, and how, price competition may affect
the capital position of a bank. In this respect, we can formulate two hypotheses, depending on
our assumptions about the determinants of bank capital structure.
According to one argument, the amount and composition of bank capital would be mainly
determined by the provisions of solvency regulation. Indeed, the existing micro prudential
framework defines some minimum capital requirements to cover for the unexpected losses,
provided that banks build appropriate provisions for the expected losses. Then, if solvency
requirements are binding, the capital ratio of a bank can be treated as an exogenous constant,
simply fixed by regulation.
If this argument is true, we should expect a change in price competition to have no impact on
the capital ratio of the bank, just because it is fixed at the target set by solvency requirements.
By implication, an increase in price competition would only have the effect of reducing bank
profitability, while it would not change the bank capital ratio. Then the overall effect of higher
competition on bank solvency would be negative, thanks to the decrease in bank profits.
However, some studies have also shown that banks, even when subject to minimum solvency
requirements, tend to hold more capital than required by regulation as they implement an active
management of their capital; in other words, they determine the optimal amount of capital with
respect to the credit risk of the assets in their portfolio and then adjust their capital levels over
time according to their targets. If this counterargument holds, then we can infer that a change in
the competitive conditions may affect the optimal solution of the bank capital problem.

For instance, an increase in price competition by reducing the profit margins of a bank and,
consequently, the amount of possibly retained earnings may induce credit institutions to set a
higher target for their capital ratios, to ensure an adequate level of solvency in case of bank
distress. Then, if banks are able to raise capital in the short term, higher competition may also
imply an increase in their equity-asset ratios. In such a case, the increase in price competition
would have two counteracting effects on bank solvency: on one side, a reduction in bank
profits, and on the other, a rise in bank capital. If the decrease in bank profits prevails over the
increase in bank capital, the overall effect of higher competition would be negative, with more
competition reducing bank solvency. Conversely, if the profitability effect is smaller than the
capital effect, an increase in price competition would improve bank solvency.
In fact, the two explanations of the bank capital dynamics presented here are not necessarily
incompatible, given that the decisions banks make regarding capital structure may be
determined both by the incentives of capital requirements and by the optimal assessment of
the asset credit risk. Then, the two hypotheses define the range of effects we can observe in
the empirical analysis: if banks fulfill their capital requirements in a relatively passive way,
then the researcher can expect price competition to reduce bank solvency. However, if banks
adopt a more active management of their capital, the relationship between price competition
and bank solvency may be positive or negative, depending on the relative size of the
profitability effect and of the capital effect.
Many factors, such as the conditions for market entry, the quality of bank regulation and
supervision, and the type of bank business model, may have a decisive role in changing the
size of these effects. For this reason, the researcher introduces some interaction terms for the
measure of price competition and the country specific indicators of bank regulation and
supervision, and of market entry, to understand how they may affect the competition-
stability nexus.
B. Liquidity Risk
Liquidity risk is the risk that a bank will not be able to meet its short-term payment
obligations, either because it is notable to accrue enough funding on the wholesale market
(funding liquidity), or because its securities or investments cannot be sold quickly enough to
get the right market price (market liquidity). For the purpose of this analysis, the researcher
focuses our attention on the concept of funding liquidity risk: the researcher explore how bank
competition may affect the liquidity position of financial intermediaries, by considering their
availability of liquid assets in relation to their short-term funding needs.
The researcher can formulate the hypotheses in terms of two possibly competing arguments.
Does competition increase the funding liquidity risk of banks, by inducing them to get funds
from short-term wholesale markets, which may be cheaper in good times but not stable over
time? Or does competition induce banks to increase their availability of liquid assets to cover
their future funding needs, given that low profit margins preclude banks form relying on
costly funding sources?
In the first argument, competition may increase the amount of short term borrowing; whereas
in this second argument competition may induce arise in the holdings of liquid assets. In fact,
the two effects may not be exclusive; a bank may obtain short-term funding from the
wholesale market and then purchase securities such as government bonds to increase the
availability of liquid assets.
Then, in order to analyze the overall impact in terms of the liquidity position, we introduce, as
a dependent variable, the ratio between liquid assets and short-term borrowing. An increase in
this ratio would mean an improvement in the liquidity position of a bank, while a reduction
would imply an increase in the bank liquidity risk.
The relationship between price competition and liquidity risk has not been explored in the
empirical literature, and only few theoretical papers have suggested some possible
explanations. Carletti and Leonello (2012) model the portfolio allocation problem of banks
between reserves or loans and, in particular, examine the ability of banks to withstand
liquidity shocks in the case of a bank run. They show that the model has two equilibriums: a
no-default one and a mixed one with safe and risky banks. The authors explain that under
intense market competition (with low lending rates) banks keep enough reserves, while in the
presence of market power some banks default with positive probability.
The empirical prediction of this model would be that competition has a positive impact on
bank liquidity, because banks subject to stronger competition tend to keep a larger buffer of
liquid assets in relation to their short-term borrowing. In this respect, competition would
enforce a self-discipline mechanism on bank funding decisions, because banks with low profit
margins would not be able to afford costly funding sources and would then need to behave
more prudently in terms of liquidity management.
C. Credit Risk
Credit risk is the risk that a borrower will not be able to repay the debt to a bank. In this sense,
the debtor may be the receiver of a bank loan, the issuer of a debt security, or even another
bank borrowing in the interbank market. Given the main focus of banking activity on credit
provision, we analyze the effects of price competition on the quality of bank lending, by
investigating the credit risk of the loans extended to customers.
In general, an increase in price competition implies a decrease in the lending rates charged by
banks to borrowers. However, this may affect the credit risk of the loan portfolio in two
different ways. In one case, corresponding to the argument in Boyd and De Nicolò (2005), the
reduction in lending rates may improve the credit conditions for borrowers by making it easier
for them to repay bank loans and then by reducing the probability of default on bank credit. If
this improvement in credit quality is extended to the whole portfolio of a bank, then an
increase in price competition may reduce the average credit risk of the loan portfolio. In the
other case, the decrease in lending rates may contract the profit margins from the provision of
credit, thereby potentially reducing the franchise value of the financial intermediary. As a
consequence, if managers are interested in increasing bank profitability, banks may increase
risk-taking by extending more credit also to riskier borrowers, with consequent rise in the
average credit risk of the loan portfolio.
These two effects may not be mutually exclusive, since they concern two distinct aspects of
credit risk determination. In the first case, price competition directly affects the risk from the
borrower’s side, by reducing the adverse selection problems in the credit market between
lenders and borrowers. In the second case, price competition has an effect on the amount of
risk that the lender swilling to take, in order to achieve a given target for bank profitability.
Moreover, if banks are able to screen and differentiate borrowers with respect to their credit
risk, we may also expect that market power may be used by some banks to exercise price
discrimination across loan applicants on the basis of their creditworthiness. As a consequence,
banks with large market power would be able to charge different lending rates as a function of
the borrower’s credit risk, while banks with limited market power would be constrained to
apply low lending rates to all applicants. In such a case, high risk borrowers would have an
incentive to get credit from banks with little market power because they apply lower interest
rates. This could also explain why banks with large market power may have an advantage in
terms of the credit quality of their loan portfolio.
 Lerner index
The Lerner index (or price-cost margin) is a popular measure of market power in empirical
research. The market power of a firm is identified by the divergence between the firm’s price and
its marginal cost. The price and marginal cost should be equal in perfect competition, but will
diverge in less competitive environments.
The theoretical foundation of the Lerner index is rooted in static oligopoly theory. Let us suppose
a quantity-setting oligopoly model (Cournot model).
Although the Lerner has been known by economists since the mid-1930s, its application to
banking is relatively recent due to the difficulty of assessing marginal costs. Marginal costs have
only been econometrically estimated during the last two decades and are extracted from the
estimation of the cost function. Cost function is often assessed using the intermediation approach
(see the Box 2) from a translog equation including a single output (total assets) and three inputs
(labor, deposit, and physical capital).

This indicator is a good measure of individual market power. It allows researchers to simply
quantify the pricing market power of individual bank. The Lerner index has the main advantage to
be bank-specific and to vary over time, allowing comparison of market power among banks
and/or over the period.

Many papers have tried to assess banking competition by averaging the individual Lerner indices
(Ferna´ndez de Guevara et al., 2005, 2007; Maudos and Sol´ıs, 2011; Weill, 2013, among
others).
The main reasons for the popularity of the Lerner index are its simplicity, its straight forward
interpretation, and the fact that it does not pose stringent data requirements. Insofar as the Lerner
index provides a firm-year specific measure of market power, it offers the possibility of studying
the evolution of bank pricing behavior over time. This indicator has other interesting advantages.
The Lerner index is a flexible indicator and does not require defining the relevant market. It
allows market power to be measured separately for the different banking markets (geographic
and by products). Furthermore, researchers may easily disentangle monopoly and monopolony
power by excluding financial costs to total costs and deposit prices (Turk Ariss, 2010). Finally,
the Lerner index can be calculated with a limited number of observations. The latter advantage is
far from anecdotal insofar as competitive concerns occur mainly when the number of firms is
limited (in such cases, the marginal costs may be proxies by average costs).
The Lerner index, however, suffers from major theoretical and practical limitations. In fact, it is a
measure of pricing market power and not a proxy of competition. In other words, an increase of
average market power over time can be consistent with an increase in the intensity of
competition. Contributions show that there are theoretically possible scenarios in which price-
cost margins increase with more intense competition (Stiglitz, 1987, 1989; Bulow and
Klemperer, 2002; Amir, 2010, among others). 11
Recent works show that even if individual
Lerner indices decreases with competition, the average degree of market power may increase,
decrease or remain stable due to the reallocation effect from inefficient to efficient firms (Boone,
2008; Boone et al., 2013). Efficient firms have higher price-cost margin than their counterparts.
Thus, the weighted average Lerner index can increase if the increase in the market share of more
efficient firms over compensates the decrease of the respective individual Lerner indices.
Other practical concerns have been raised about the Lerner index. Vives (2008) maintains that the
Lerner index is not able to appropriately capture the degree of product substitutability. Oliver et
al. (2006) emphasize that, when a bank’s risk taking is not accounted for, the Lerner index could
overestimate market power, because banks that in relative terms spend more of their resources
granting credits enjoy higher margins. This issue is particularly problematic for studies employing
the Lerner index to investigate the competition-stability nexus (Berger et al., 2009; Turk Ariss,
2010; Beck et al., 2013). Koetter et al. (2012) point out that the conventional approach of
computing the Lerner index assumes perfect technical and allocate efficiency. Unfortunately,
banks rarely operate under perfect efficiency. Operating costs and efficiency vary depending on
the economic environment in which banks operate (Chaffai et al., 2001). As a consequence,
differences across countries (or changes over time) in Lerner indices can be justified by
differences (or changes) in non-competitive factors.
2.2.2. PANZAR AND ROSSE MODEL
The Panzar-Rosse model (Rosse and Panzar, 1977; Panzar and Rosse, 1982, 1987) is the most
widely applied assessment of competition in the banking literature. This indicator catches the
transmission of input prices on firms’ revenues. Weak transmission is inter- preted to indicate the
exercise of market power in pricing and higher values indicate more competition.
The intuition is straightforward in two opposite cases : collusion and perfect competition. For a
monopolist, marginal cost equals marginal revenue at the equilibrium. After input prices
increase, marginal cost increases. To maintain the equilibrium between marginal cost and
marginal revenue, the monopolist should increase the marginal revenue by redu- cing the total
quantity (insofar as marginal revenue is a decreasing function of quantity). Rosse and Panzar
(1977), shows that total revenue is reduced if the price elasticity of demand exceeds one.
Intuitively, an increase in marginal cost reduces quantity but increases output price. If the
demand elasticity exceeds one, the gain due to price increase does not compensate for the loss
due to reduction of quantity. By contrast, in a competitive setting an increase in input prices
induces an increase in total revenue. Because cost functions must be homogenous of a degree of
one in the input prices, any increase in input prices generates an equal percentage increase in
costs. A firm’s revenue changes by the same percentage as its total cost, and so by the same
percentage as its inputs prices to ensure the zero profit condition (total cost equals total revenue).
The required adjustments in the total quantity are achieved by a reduction in the number of firms
(long-run equilibrium). As a consequence, an increase of 1 percent in input prices induces an
increase of 1 percent of total revenue in competitive markets.
From this theoretical framework, the identification of competitive conditions is obtained by
calculating the sum of the elastic ties of the revenue with respect to all input prices. The sum of
elasticity, often called the H-statistic, ranges from −∞ to +1. The greater the transmission of cost
changes into revenue changes, the more competitive the market is. Under perfect competition,
input prices and total revenue increase by the same percentage and the H-statistic equals one.
Shaffer (1982) proves that the H-statistic value equals one for a monopoly in a contestable
market (free entry). The H-statistic is null or negative for a monopoly. An increase in input
prices induces a reduction of total revenue under certain assumptions (e.g. demand elasticity
higher than one). Vesala (1995), documents that the H-statistic is non-positive in the
monopolistic competition equilibrium without threat of entry or for a collusive oligopolistic. This
measure is between 0 and 1 for a monopolistic competitor (Rosse and Panzar, 1977; Panzar and
Rosse, 1987; Vesala, 1995).

2.3. MEASUREMENT OF COMPETITION IN BANKING

Many scholars argued about the measures which can be used to determine and explain the
competitive nature of banks. The review of previous literature shows the increasing importance
of the following measures that are extensively used to measure bank competition. The
following table provides the description of the following measures including HHI, Lerner
index, Boone indicator, Z-score and H-statistic.
Previous literature suggests that HHI, Lerner index and H-statistic are regarded as the main
measurements used in empirical studies to measure bank competitiveness. The study by Bolt
and Humphrey (2015) used three measures of banking competition including HHI, Lerner
Index and H-statistic. This may also imply that negative correlation among these three
measures. For instance, when HHI index shows that competition in banking sector is strong, the
outcomes of Lerner index and H-statistic shows the different outcome. Results of the study by
Bolt and Humphrey (2015), with the sample of total 2655 banks and 382 financial institutions
reported weak relationship among three measures of competition in relation to each other,
stating that banks with the highest loan rates are the least competitive. One explanation for this
is that three measures of competition measure bank competitiveness differently from each
other. That is to say that result of HHI index is uncorrelated to the outcomes of Lerner index
and H-statistic. Another study of Bolt and Humphrey (2015) uses “competition efficiency”
theory, with three measures of banking competition including HHI, Lerner index and H-
statistic. Results of the paper suggest evidence which supports the argument that HHI, Lerner
index and H-statistic are uncorrelated with each other and US banks which has the lowest rate
for consumer loans are considered to be the highly competitive. Moreover, Boone indicator and
Lerner index mostly used bank competition measures have strong negative relationship with
non-performing loan ratio of banks (Bolt and Humphrey, 2015). Therefore, based on the
available analysis, it can be stated that bank fragility theory has been supported.

2.4. COMPETITION IN BANKING: GOOD OR BAD?

Measuring competition is not an end for policy purpose. Theories relate the level of competition
in banking industry with financial stability and/ fragility. Though there is a belief about a
positive effect of normal competition on stability of the financial sector and hence on economic
development, still there is no an unambiguous argument on the relationship between bank
competition and the resultant effect on stability and / fragility in the sector. Proponents of
competition relate banking competition with stability in the financial system. The theoretical
model of Boyd and De Nicolo (2005) showed that a bank operating under less competitive
system will take higher risk in their loan portfolio as banks charge higher interest rate for
borrowers (will create moral hazard).Supporting this, Cetorelli (2001) stated that monopoly in
banking would lead to lower interest rate for saver and higher interest rate for borrower and
hence distort entrepreneurial incentives toward the undertaking of excessively risky projects.
This collectively will lead to instability in credit market and systematic failure. Moreover, less
competition in banking will let banks to engage in risky activities (due to too-Big- to fail
incentive) and hence will have a high probability to fail (Brian A, etal, 2014).

Contrary to the above argument, opponents of competition relate banking competition with
financial crisis. Different theoretical models based on Charter-value of banking predicted that
bank competition will lead to instability. In this view, as summarized by Beck (2008), profits
provide buffer against fragility and provide incentives against excessive risk taking in a more
competitive banking system. In support of this, Xavier (2010) put two channels how bank
competition creates instability. The first channel is through worsening the coordination problem
of depositors or investors which will foster bank run. The second channel is by letting banks to
take high risk in their portfolios.

2.4. BANKING IN ETHIOPIA

2. 4.1. HISTORY OF BANKING IN ETHIOPIA

A reference to the Ethiopian history reveals that the first bank in the country, Bank of Abyssinia
was founded during the reign of Emperor Menelik II in February 1905. Due to a foreign
domination of its management (mainly the British), the then Bank of Abyssinia was forced to
dissolve and in its place was established the Bank of Ethiopia in 1931 whose management was
still left to foreigners due to the then lack of skilled manpower in the country. The Bank of
Ethiopia was later replaced by the State Bank of Ethiopia soon after the war with Italy. The latter
was the first bank in the country fully controlled and owned by the Ethiopian government. In the
meantime, however, a number of foreign banks had opened their branches in the country, most
of them with an interest to have control over the nation’s economy. It was the State Bank of
Ethiopia that gave rise to the present Commercial Bank ofEthiopia (CBE) and National Bank of
Ethiopia (NBE). During the Dergue reign, CBE had remained as the only participant in the
country’s commercial banking sector.
However, following the 1991 takeover by the present government and accompanying
encouragement of private investment, a number of private banks have emerged in the country’s
financial sector. Accordingly, Monetary and Banking proclamation No.83/1994 and the
Licensing and Supervision of Banking Business No.84/1994 laid down the legal basis for
investment in the banking sector. Consequently, shortly after the proclamation the first private
bank, Awash International Bank was established in 1994 by 486 shareholders and by 1998 the
authorized capital of the Bank reached Birr 50.0 million. Dashen Bank was established on
September 20, 1995 as a share company with an authorized and subscribed capital of Birr 50.0
million. 131 shareholders with subscribed and authorized capital of 25.0 million and 50 million
founded bank of Abyssinia. Wegagen Bank with an authorized capital of Birr 60.0 million
started operation in 1997. The fifth private bank, United Bank was established on 10th
September 1998 by 335 shareholders .Nib International Bank that started operation on May 26,
1999 with an authorized capital of Birr 150.0 million. Cooperative Bank of Oromia was
established on October 29, 2004 with an authorized capital of Birr 22.0 million. Lion
International Bank with an authorized capital of Birr 108 million started operation in October 02,
2006. Zemen Bank started operation on June 17, 2008 with an authorized capital of Birr 87.0
million. Oromia International Bank started operation on September 18, 2008 with an authorized
capital of Birr 91 million. In addition, recently Buna international bank and Berhan international
bank are started operation in the country (NBE, 2009).
2.4.2. REVIEW OF COMMERCIAL BANKING PRACTICES IN
ETHIOPIA

In Ethiopia, 12 private and three state owned banks are operating at the end of June 2009.
Despite a rapid increase in the number of financial institutions since financial liberalization, the
Ethiopian banking system is still underdeveloped compared to the rest of the world. The use of
checks is mostly limited to government institutions, NGOs and some private businesses.
Commercial banks in Ethiopia provide the same services with the same operational style that
they used to offer before decades. The common banking functions provided by public and
private banks in Ethiopia are deposit mobilization, credit allocation, money transfer and safe
custody. Banks in Ethiopia are unable to improve customer service, design flexible and
customized products, and differentiate themselves in a market where 24 product features are
easily cloned. Ethiopian banking is unable to come from long way of being sleepy to a high
proactive and dynamic entity.
The Ethiopian banking industry as a whole has a network of 636 branches as per the fourth
quarter bulletin 2008/09 of the National Bank of Ethiopia, which is the lowest compared to the
size of the country (1.1milion square km) and number of population (78 million) and this shows
that the number of population being served by a single branch stood at around 105,000 With
such highly scattered branch network and disintegrated working system it is hard to ensure
efficient flow of financial resources and optimize the contributions of the entire financial system
to the development processes. All banks in Ethiopia are too late to move with technological
advancement and they should clearly chart out the time schedule for their integration and
technological advancement. Some of the banks even today do not have information websites,
which can help them to provide at least the information on financial services offered by them
(NBE , 2008/09).
 CHAPTER THREE
3. RESEARCH METHODOLOGIES
3.1. BACKGROUND OF THE STUDY AREA

Addis Ababa is the capital city of Ethiopia and the diplomatic capital of Africa with a population
of greater than 3 million. It is situated at 2,380 meters above sea level on a well-watered plateau
and is the seat of the national government.
It was chosen as a study area because: the head office of each bank that represents the whole
branch in the country and the national bank of the country which is found there and in addition
educated bank employees who have better understanding about Competition and Financial
stability as compared to other locations in the country are found in Addis Ababa.
3.2. RESEARCH DESIGN

Research design is a blueprint that is benchmarked to implement the study through the data
collection and analysis phases of the research project. It ensures that the study is relevant to the
phenomena while utilizing economical procedure (Churchill & Iacobucci, 2005). The study will
adopt causal research design. This design determines reasons for current status of the phenomena
under the study. Its variables of interest may not be manipulated as in experimental research
(Cooper & Schindler, 2009). With causal research design, the study will have the capacity to
determine the effect of the independent variable(s) on the outcome variable (dependent) in a
study (Ginsburg, 2011). The causal research design is relevant since the study sought to establish
the causal effect between independent variables and dependent variable of commercial banks in
Ethiopia.
3.3. TARGET POPULATION AND SAMPLE SIZE

Target population can be portrayed as the components that meet certain criteria for incorporation
in an investigation. It comprises all individuals from a genuine or theoretical arrangement of
individuals, occasions or articles (Borg & Gall, 2007). Both private and public commercial banks
will be included as a target population. Purposive sampling technique will be used to select the
target population for this study that means all those commercial banks will be included in the
target population for this study. The analysis is conducted for a sample of 17 commercial banks in
the Ethiopian banking industry, based on their bank balance sheet data provided by Bank scope.
From the specialization point of view, the sample Development Bank of Ethiopia and other
commercial banks which were commencing recently are not included in the sample, to ensure
some homogeneity in the type of banking activities and to allow for data comparability. The data
are available on an annual basis from 2016/17 to 2019/20.
In the base line specification, the researcher estimate the following panel regression by using
bank fixed effects:
𝑅i𝑠𝑘ij𝑡=ai+𝛽1𝐶𝑜𝑚𝑝ij𝑡−1+Z𝐵𝑎𝑛𝑘𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠ij𝑡−1+∆𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠j𝑡−1+Eij𝑡
Where i indicate the bank, j defines the country, and t denotes the year. The dependent variable
is a measure of bank risk that is solvency risk, liquidity risk, and credit risk. The key explanatory
variable is an indicator of price competition at the bank-level, the Lerner Index, which measures
the market power of a bank. We also include, as control variables, bank-level balance sheet
variables and country-specific macroeconomic variables. In the baseline specification, we
introduce one-year lagged terms for the explanatory variables.
For each type of bank risk (solvency, liquidity, and credit), the researcher estimate different
specifications for panel regressions, in order to take in to account the role of other factors which
can interact with price competition in affecting the stability of financial intermediaries.
1. To analyze the effect of market power and of market entry, the researcher runs the following
regression:
𝑅i𝑠𝑘ij𝑡=𝛼ij+β1𝐿𝑒𝑟𝑛𝑒𝑟ij𝑡−1+β2𝐿𝑒𝑟𝑛𝑒𝑟ij𝑡−1·𝑀𝑎𝑟𝑘𝑒𝑡𝐸𝑛𝑡𝑟𝑦j𝑡−1+Δ𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠j𝑡−1

+𝑍𝐵𝑎𝑛𝑘𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠ij𝑡−1+Eij𝑡
Where Market Entryjt-1is a country specific variable for market contestability, measuring the
intensity of the barriers to entry and of the activity restrictions to financial intermediaries,
based on the World Bank Survey on Bank Regulation and Supervision. In this respect, the
interaction term 𝐿𝑒𝑟𝑛𝑒𝑟ij𝑡−1·𝑀𝑎𝑟𝑘𝑒𝑡𝐸𝑛𝑡𝑟𝑦j𝑡−1may be considered as an indicator of bank market
power, adjusted for the entry conditions in a given market.
This may be useful also in considering the possible future dynamics of the market, which could
affect the competitive behavior of the incumbents. A bank may currently have low market
power in terms of pricing behavior, but it may operate in a market which significantly restricts
the entry of new institutions; this implies that, in the future, it might be able to increase prices
or it may collude with other incumbents. Also, a bank may dispose of a relatively high market
power but in a market which is widely open to the entry of potential competitors; therefore, in
the future it might be able to preserve that pricing power only if the supplied products and
services are discernibly better than the ones offered by the competitors.
As the empirical analysis would suggest, the market power, per se meaning the ability of a bank
to profitably raise the price of a product or a service over the marginal cost may not necessarily
imply negative effects on stability, as long as the market is relatively contestable and subject to
low barriers to entry. However, if high entry barriers limit the access of other banks to the
market, a credit institution with some degree of market power could be interested in exploiting
the additional profits to further expand its activities and increase risk taking. In fact, entry
restrictions can significantly encourage such risk-taking attitudes from incumbent banks
operating in a concentrated and closed market. Indeed, they may take advantage from
increasing the size of their balance sheets and then their systemic relevance, through the higher
likelihood of an implicit support by the government. This would actually be a source of major
concern for our analysis. On the contrary, such incentives would be less relevant in a
contestable market, where new entrants could easily strata banking business; in such a case, a
bank potentially interested in more risk taking would have to internalize the additional costs
from an excessive expansion of its activities, in terms of the higher probability of default, since
the case of a government intervention might be less likely.
2. To examine the interaction of market power with bank regulation and supervision, the
researcher estimated the following equation:
𝑅i𝑠𝑘ij𝑡=aij+β1𝐿𝑒𝑟𝑛𝑒𝑟ij𝑡−1+β2𝐿𝑒𝑟𝑛𝑒𝑟ij𝑡−1·𝐵𝑎𝑛𝑘𝑅𝑒𝑔𝑢𝑙𝑆𝑢𝑝𝑒𝑟𝑣j𝑡−1+Δ𝐶𝑜𝑢𝑛𝑡𝑟𝑦𝐶𝑜𝑛

𝑡𝑟𝑜𝑙𝑠j𝑡−1+𝑍𝐵𝑎𝑛𝑘𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠ij𝑡−1+Eij𝑡
Where 𝐵𝑎𝑛𝑘 𝑅𝑒𝑔𝑢𝑙 𝑆𝑢𝑝𝑒𝑟𝑣j𝑡−1 is a country specific variable for the quality of the regulatory
and supervisory framework: In particular, the researcher consider some indicators from the
World Bank Survey on Bank Regulation and Supervision, concerning various aspects: capital
stringency, depositor protection schemes, supervisory effectiveness, supervisory
independence, and presence of government-owned banks. The researcher analyzed the
interaction of the main explanatory variable for market power, the Lerner index, with an
indicator of country specific bank regulation and supervision, by using a relevant
subcomponent of the World Bank Survey, depending on the specification for the dependent
variable.
3.3. DATA SOURCE AND METHOD OF COLLECTION

The study was conducted by collecting data from secondary sources. Secondary data will be
collected from published annual financial statements of the respective commercial banks in
Ethiopia. In order to get sufficient and reliable data that represents the whole head office
organ of the selected banks both primary and secondary data will be collected from the
 Head office and Nation The researcher used data from a variety of sources, by combining
bank level balance sheet data on market entry conditions, bank regulation and supervision,
and macroeconomic developments. In particular, the researcher obtained the bank level
balance sheet variables from annual audited financial statements
Bank Competition
The degree of competition in the banking market can be analyzed through different
measures that are related to three different concepts: price competition, market
contestability, and market concentration. In particular, I used as key explanatory variables
in my analysis:
1. Individual Bank specific measures of price competition(in particular the Lerner index)
2. Country level indicators of regulatory restrictions.
The researcher measured competition at the bank level by computing the Lerner Index,
which is a measure of bank market power. Indeed, it is defined as the ratio between the
markup (the difference between the price and the marginal cost) and the average price of
bank activities:

Lernerit
P
it  MC it

P
it

The researcher investigated the pricing behavior of banks producing a single output and we
proxy the price by the ratio of total revenues to total earning assets, where total revenues
include interest income and non-interest operating income and equity accounted profit/loss
operating income.
In the analysis the researcher also introduced the market share of a given bank, which may be
representative of the banks’ position in terms of market concentration. The rationale for that is
the structural distinction between market power and market concentration; for instance,
Claessens and Laeven (2004) have shown that even if market concentration may be a good
indicator for market structure, highly concentrated markets can also be quite competitive, either
because banks price loans and deposits as in a competitive setting or because the market is
open to new entrants.
FINANCIAL STABILITY
The researcher considered three dimensions of financial stability at the individual bank level
with respect to distinct sources of risk: the solvency risk, the liquidity risk, and the credit risk of
the asset portfolio.
The solvency risk can be measured through various bank balance sheet indicators, which are
directly available on Bank scope (equity-asset ratio, regulatory capital ratio) or which can be
computed from that (Z-Score). For the purpose of the empirical analysis, and following other
works on the topic (Beck, De Jonghe and Schepens, 2013; Berger, Klapper and Turk-Ariss,
2009), we use the Z-Score as a measure of the distance of a bank from insolvency. It is
computed as the sum of the equity-asset ratio (E/A) and of the return on assets (RoA), divided
by the standard deviation of the RoA, as follows:
𝑍−𝑆𝑐𝑜𝑟𝑒i𝑡 𝐸/𝐴i𝑡+𝑅𝑜𝐴i𝑡
=

𝜎(𝑅𝑜𝐴)i𝑡

Where higher value means higher solvency of a bank: In order to reduce the impact of the
changes in assets during the year, we use the Return on Average Assets. Moreover, to allow
for the variability of our indicator, we compute the standard deviation of the Return on
Average Assets on rolling base for a four-year interval.
The funding liquidity risk can be measured through different indicators which can be
computed from the balance sheet data available in Bank scope (Bonfirm and Kim, 2012). In
particular, in our analysis, we define the Liquidity Ratio as the ratio between liquid assets and
short-term borrowing it explains the size of the liquid assets buffer a bank has at its disposal.
The credit risk is the risk related to the quality of bank assets and it mainly includes the credit
risk of the loans extended by the bank and of the securities held on balance sheet. Provided
that the major component of on-balance-sheet assets is given by loans, a good measure for
the asset portfolio risk is the Non-Performing Loans (NPLs) ratio, which is available from
Bank scope.
Bank Regulation and Supervision
To capture the effects of the quality of the country-specific regulatory framework on the
stability of financial intermediaries, we use some indicators from the national bank of Ethiopia
Survey on Bank Regulation and Supervision.
As for the quality of prudential regulation and supervision, the researcher considered four
indices: Capital Regulation Stringency, Supervisory Power, Supervisory Independence, and
Deposit Insurance Scheme.
3.4. DATA COLLECTION INSTRUMENT

The researcher was applied the study review guide document that was used to extract and
compile the financial information for analysis. The information was extracted from the financial
statements, specifically, statements of financial position, notes to the accounts and the income
statement. Therefore, the sample data was gathered from year 2016 ending in the year 2021
ending. The extraction of information for all the variables in the study was based on the
published annual financial reports of commercial banks between years 2016 and 2021.
3.5. DATA COLLECTION PROCEDURE

A study permit from Commercial Banks in Ethiopia was acquired as a license for data collection
from published financial statements of commercial banks in Ethiopia which is approved by
National Bank of Ethiopia. This study was conducted using panel data which comprised years
between 2016 and 2021 consisted of 17 commercial banks.
3.6. DATA ANALYSIS AND PRESENTATION

In this study, the researcher was used both quantitative data comprising cross section and panel
data. The study was carried out both descriptive and inferential statistical analysis. Descriptive
statistics employed mean, standard deviation, maximum and minimum values and trend analysis.
Inferential statistics analysis was analyzed using correlation and regression analysis. Correlation
analysis was carried out to establish the directional relationship between two variables under
study. Regression comes in play as the researcher intended to ascertain the effect of bank
competition on financial stability of commercial banks in Ethiopia. Information extracted from
the financial statement of each commercial bank was presented in excel work sheet before
importation to EViews7 program that supported the analysis. Data was presented in form of
tables, figures and graphs.
 CHAPTER FOUR
DATA ANALYSIS AND PRESENTATION
The researcher presents the results of the empirical analysis, distinguishing the different
types of bank risk: solvency, liquidity, and credit risk. Also, for each type of bank risk, the
researcher discussed the estimates of distinct regression specifications, aimed at exploring
the questions introduced in the previous section: the effect of market power and of entry
barriers on bank stability; the interaction between market competition and banking
regulation and supervision, and the implications thereof for financial stability.
A. Solvency Risk
In this section the researcher explored whether, and how, price competition may affect the
solvency risk of financial institutions specifically commercial banks operating in Ethiopia, as
measured by the Z-Score.
From the specification in Table 2, the researcher observed that an increase in the Lerner Index
for instance, a decrease in price competition improves the bank solvency in terms of the Z-
Score. In particular, a one-standard deviation rise in the banks’ market power implies an
increase in the banks’ Z-Score by 4.68, which a sizeable effect is given that from the summary
statistics - the bank-level Z-Score has a mean of 9.73 and a standard deviation of 18.88. This
means that banks with large market power also present higher solvency than banks with limited
or no market power. This result, consistent with the empirical findings on competition and
solvency in the previous literature, confirms that an increase in market power may improve
bank solvency by increasing the profit margins available for the bank.
This potentially negative effect of price competition on bank solvency is even stronger if we
consider as an explanatory variable instead of the bank-level Lerner Index the country-average
Lerner Index, which reflects the overall competitive conditions in the economy. Indeed, a one-
standard deviation increase in the average market power of banks in a given country is
associated with a rise in the bank Z-Score by 7.29, an effect 56 percent larger than the effect of
a corresponding increase in bank market power. This means that, if the other banks operating in
a given country use the additional profits from their market power to build adequate capital
buffers, each individual bank will also be incentivized to improve its solvency; that is, the
opportunity cost of being insolvent is higher in a banking system where, on average, the other
banks are solvent.
Also, bank balance sheet factors may affect the solvency position of credit institutions. The
researcher considered a series of control variables, regarding the composition and quality of
bank assets, the diversification in bank activities, and the sources of bank funding. The ratio of
government bond exposures to total assets may be considered as an inverse measure of the
banks’ appetite for risk, provided that government bonds are high-quality assets. Indeed,
banks with a larger share of government bonds among their total assets also display higher
solvency in terms of the Z-Score.
Also, the growth rate of total assets may be used as an indicator of the potential risks coming
from an excessive expansion in the bank balance sheet; if banks increase their assets in a
disproportionate way, for instance by extending new credit to riskier borrowers, this may
increase the solvency risk of a bank, because of the losses coming from these new bank
activities. Moreover, the ratio of nonperforming loans to total assets is an inverse measure of
the quality of bank assets, and is associated with a worsening of bank solvency. The banks
which present a higher rate of non-performing loans, because they invest in riskier assets, are
more frequently subject to losses and are therefore less solvent. Finally, the ratio of non-
interest income over total revenues is a measure of diversification in the sources of bank
income and it shows a positive impact on bank solvency. An increase in the diversification
ratio implies better bank performance, because banks receiving a larger fraction of their
income from fee-based activities would present lower profit volatility than other banks more
reliant on interest revenues.
In Table 2, the researcher investigated whether, and how, market entry conditions may affect
the relationship between price competition and bank solvency. The positive impact of market
power on bank solvency may be significantly reduced if credit institutions operate in a market
with heavy restrictions on banking activities and a high percentage of denied applications.
Such limitations to market contestability might actually reverse the sign of the relationship
between price competition and bank solvency.
The researcher can give some economic meaning to the estimation results by looking at the
threshold values of the interacted variables, for which we can observe a change in the sign of
the relationship. If the supervisory authorities in charge of assessing the applications for
banking licenses had to reject more than 85 percent of submissions, an increase in the market
power of the incumbent banks would have the effect of reducing their solvency; therefore, in
such a case, more price competition among the existing banks would be beneficial for
financial stability. Also, if the regulatory authorities applied the maximum level of restrictions
to bank activities (Activity Restrictions may take a maximum value of 12), the positive effect
of market power on solvency would be completely offset by the negative impact of
restrictions on activity.
The rationale behind the results is that, when access to the market is restricted to potential
competitors, the incumbent banks may be induced to exploit their position in order to further
increase their profits and take more risks. While in a contestable market credit institutions may
be prevented from increasing their risk taking by the concern for the default risk, in a restricted
market with limited entry, large banks disposing of market power know that in the case of
bank distress they might benefit from some implicit public support, because of their systemic
relevance. This may have some relevant policy implications for regulatory reforms in the
financial sector.

Improving market contestability by liberalizing activity and by allowing for market entry may
be beneficial not only for consumer welfare but also for financial stability, to the extent that it
can prevent the incumbent banks from exploiting the advantages of market concentration and of
systemic relevance to increase their risk taking. In this respect, country authorities should be
interested in modifying those banking activity regulations which may unduly restrict market
contestability, unless they are required to pursue other relevant policy objectives.
In fact, we can argue that not all the regulations which restrict entry should have a negative
effect on stability. Indeed, if the regulations for market entry are aimed at establishing more
stringent requirements based on prudential considerations that is, to promote the safety and
resilience of the entrants some market power may still have a positive impact on bank
solvency (through the effect on bank profitability), provided that the level of entry
requirements is above a given threshold. For the countries in the sample, the indicator of
prudential entry requirements proposed in the World Bank Survey is included in a range
between four and eight, and its average value is 7.80. The threshold based on the estimation
coefficient is equal to 5.81. This means that, above that value, the prudential entry
requirements may help ensure that incumbent banks with larger market power would adopt
adequate management of their solvency. In this respect, entry regulations would have an effect
on bank solvency which is analogous to the impact of prudential requirements for capital
adequacy. In the absence of such prudential entry requirements, that is below that threshold,
the opposite effect would hold: price competition would have a positive effect on the solvency
of incumbent banks, although this would not necessarily guarantee the safety of the entrant
banks.
In Table 3, the researcher examined the effect of the interaction between price competition and
bank regulation and supervision on the solvency of credit institutions.
Specifically, we explore whether, and to what extent, capital regulation may play some role in
affecting the nexus between competition and solvency. Based on our hypotheses, we can
identify two possible arguments. First, if bank capital is considered as an exogenous constant
fixed by regulation, then the negative effect of competition on solvency can be explained simply
as a consequence of the reduction in bank profits that follows the decrease in lending rates. On
the contrary, if bank capital is modeled as an endogenous variable determined by an optimal
bank decision, then the negative impact of competition on solvency may result from a
combination of two counteracting effects:
1) a substantial decline in bank profits, and
2) a modest increase in bank capital (where the second effect arises because banks adjust their
capital levels to compensate for a fall in profitability).
In order to disentangle this issue, we are interested in separating in the results of the empirical
analysis the effect of price competition from the impact of capital regulation on bank solvency.
For this purpose, the researcher introduced an interaction term between the competition measure
(the Lerner Index) and the indicator of capital stringency from the Central Bank of Ethiopia
database. In this way, the researcher can estimated the marginal effects of price competition on
bank solvency for different values of capital stringency.
In the specification of Table 2 Column 2, the researcher considered separately the coefficient
for the Lerner Index and the coefficient for the interaction between competition and capital
regulation. the researcher observed that in the hypothesis of a total absence of capital regulation,
a one standard deviation increase in price competition would imply an improvement in bank
solvency; that is, arise in the Z-Score, by almost one-standard deviation. This means that, in the
absence of capital regulation, price competition would reduce bank profitability but would also
induce banks to increase their capital base as a buffer for loss absorption. Then, in the same
regression, the interaction term for capital regulation is positive and an increasing function of
capital stringency. This implies that, in the presence of solvency requirements, an increase in
market power improves bank solvency as measured by the Z-Score, provided that banks are
induced to use the additional profits from their market power to build capital buffers.
Finally, if we combine the effects of the two coefficients, we can observe that the overall impact
of price competition on bank solvency would be negative, as long as the indicator of capital
regulation is higher than a given threshold. In particular, this threshold value for capital
stringency would be equal to 6.17, provided that the index is in a range between three and 10 for
the countries in the sample, and given that its average value is 7.03. This means that, for the
average value of capital stringency in our sample, market power would actually have a positive
effect on bank solvency.
From the decomposition of our empirical results, the researcher can explain this effect
with respect to the inter play of incentives between bank capital management and
prudential requirements.
Without capital regulation, banks would adopt a more active management of their capital and
choose their optimum capital level. In such a case, more competition could imply higher
solvency, because banks with low market power would increase their capital base to a relevant
extent, while banks with large market power could afford a lower equity-asset ratio thanks to
their profitability. But once we introduce capital requirements, banks tend to take a more
passive approach to capital management, by keeping the level of capital required by the
regulation. In that case, more competition would reduce bank solvency (or more market power
would increase bank solvency).
The researcher also estimated the interaction of market power with other aspects of bank
regulation and supervision. In Column 4 of Table 3, we can consider the effect of supervisory
independence in relation to price competition. The positive effect of market power on solvency
is an increasing function of the degree of supervisory independence. This means that banks with
large market power may still be more solvent, provided the existence of an effective and
independent supervisor induces them to manage their capital more prudently.
Also, in Column 5 Table 3, we can consider the possible role of deposit insurance. We observe
that when there is no explicit deposit insurance, the differences in bank solvency between banks
with large market power and banks with limited market power are rather small; whereas in the
presence of deposit insurance, banks disposing of some market power tend to show higher
solvency than banks with competitive pricing. In order to understand this difference, we have to
consider that in general banks with some market power obtain more profits than banks with
competitive pricing and then in the absence of changes to bank capital they are expected to have
a better solvency position.
However, if capital is endogenous, banks may increase their equity-asset ratio to improve their
resilience. In particular, they would do so depending on the opportunity cost of a potential in
solvency situation, which may depend on some institutional factors such as deposit insurance.
In fact, the absence of a deposit insurance scheme would likely raise the opportunity cost of a
potential insolvency. In such a case, banks with limited market power and consequently low
profitability would have stronger incentives to raise their capital in such a way as to offset the
negative effect of competition on bank profitability. Indeed, banks know that otherwise they
could be easily subject to a bank run if depositors fearing potential insolvency were to withdraw
their funds. On the contrary, such incentives to increase capital would be lower in the presence
of deposit insurance, because in that case banks could benefit from the protection of the insurer
for depositors. This incentive problem may explain why, under deposit insurance, banks with
limited market power could be less solvent; the potential increase in bank capital would not
compensate the decrease in the amount of profits.
B. Liquidity Risk
In this section we explore whether, and how, bank market power affects the availability of
liquid assets with respect to a bank’s short-term borrowing. The results from the baseline
specification, as presented in Table 5, reveal that a decrease in the Lerner index that is, an
increase in price competition implies an improvement in the liquidity ratio. In particular, we
observe that a one-standard deviation decrease in the bank level Lerner Index (increase in price
competition) induces an increase in the liquidity ratio by 3.7 percent for that institution. This
would be an economically significant effect, given that for the banks in our sample, the ratio
between liquid assets and short-term borrowing has mean equal to 47 percent and a standard
deviation equal to 4 percent.
This positive effect of competition on liquidity is confirmed across all the specifications, and
when we take into account the possible role of other factors for market entry and for banking
regulation and supervision.
Also, if we consider the average price competition across all banks in a given country, we notice
that a one-standard deviation decrease in the country-average Lerner Index (that is, an increase
in competition at the country level) implies an improvement in the bank level liquidity ratio by
7.4 percent, which is in terms of magnitude twice as large as the effect of a corresponding
change in the bank-level Lerner Index. This means that the intensity of price competition at the
market level may be even more important than the extent of the bank-specific market power in
affecting the incentives for bank liquidity.
Bank-level balance sheet factors and country-specific macroeconomic developments may also
have significant impact on bank liquidity as control factors. In particular, the quantity and the
quality of bank lending may affect banks’ liquidity position. Looking at balance sheet volumes,
banks with larger lending activity with respect to their total assets present a wider liquidity
mismatch between their assets and liabilities and show higher liquidity risk. But then, after
controlling for the volumes, the quality of bank lending may have a self-disciplining effect on
liquidity management: as banks with a higher rate of nonperforming loans need to have more
liquid assets as a buffer against shortfalls in the expected cash flows from borrowers. Likewise,
diversification in the sources of bank income may be relevant for liquidity: provided that fee
based revenues may be less volatile, banks with a higher fraction of non-interest income over
total revenues may need to hold less liquidity than other banks that rely more on the conjuncture
of credit markets. Moreover, bank profitability also improves the liquidity position by
increasing the amount of cash revenues available to banks.

The results obtained from the bank balance sheet controls would support the idea that at least
for the sample under our consideration credit institutions tend to implement an active
management of their liquidity by adjusting the amount of their liquid buffers with respect to
the effective risks that may affect their cash flows. The positive effect of price competition on
bank liquidity would be consistent with this approach: banks would react to the reduction in
profit margins by increasing the availability of liquid assets, in order to ensure the holdings of
adequate buffers to face future cash outflows. This may also have some policy implications for
the financial sector in Ethiopia because it shows that, on average, the banks operating adopted
a quite prudent management of their liquidity during the under analysis period. On the other
hand, even during the crisis, the banking system in the selected commercial banks was not as
subject to significant liquidity shocks such as the ones which strongly affected the banking
systems in advanced economies.
In Table 5, the researcher examined also the effect of the interaction between price
competition and market entry conditions on bank liquidity. From the results in Columns 4 and
5, we see that the positive effect of price competition (and then the negative effect of market
power) on the liquidity ratio is even larger when national regulators introduce some
restrictions on the ability of banks to engage in other activities (securities, insurance, or real
estate) or they establish some legal requirements for bank entry. We can provide some
economic explanation of this effect based on the estimation results. An increase in the activity
restrictions from the minimum (3) to the maximum value (12) would raise the benefits of price
competition for the liquidity ratio from 2.1 percent to 8.5 percent. Also, a rise in the banking
entry requirements from the minimum (4) to the maximum (8) would actually change the
marginal effect of competition on liquidity from being negative to positive that is from -2.6
percent to 3.8 percent. In the latter case, price competition may induce a positive effect on the
bank liquidity position, provided that regulators introduce adequate entry requirements above
a given threshold. In particular, the threshold level for entry requirements that would ensure
the positive effect on liquidity would be 5.61, while, in fact, the average value of this indicator
in our sample is well above that threshold (7.80). This confirms for the average value of entry
requirements in my sample the positive impact of competition on liquidity.
We can interpret these results by observing that some restrictions to bank activities and,
particularly, some requirements for entry into banking, may be necessary in order to ensure that
institutions operating in the market are managed in a prudent way. In the case of liquidity, both
activity restrictions and entry requirements support the market mechanism in which more
competition improves the liquidity position of financial intermediaries. On the contrary, in the
absence of such entry requirements, the positive impact of bank competition on liquidity might
be significantly reduced or reversed as without the proper incentives from the prudential
framework credit intermediaries might react to competition by increasing the recourse to short-
term funding sources.
In Table 6, the researcher investigated the role bank regulation and supervision has on the
relationship between price competition and bank liquidity. As mentioned earlier, the existing
framework for prudential regulation has focused mainly on capital requirements; only after
the crisis have international regulators decided to introduce some minimum liquidity ratios.
The empirical evidence observed for the commercial banks in Ethiopia supports the view
that prudential requirements for capital adequacy may strengthen the liquidity enhancing
effect of price competition. Indeed, a rise in the stringency of capital regulation from the
minimum (3) to the maximum value (10) increases the positive effect of higher competition
on the bank liquidity ratio from 2 percent to 6.6 percent. The intuition is that, if capital
regulation is binding, banks are even more incentivized by competition to practice prudent
management of their liquidity, because they have to prevent temporary liquidity shocks from
creating potential consequences in terms of insolvency. In this respect, stringent capital
regulation would increase the opportunity cost of bank illiquidity.
The quality of bank supervision may also affect the competition-liquidity nexus. Whereas the
interaction with the supervisory power displays a no significant coefficient, supervisory
independence may reduce the positive effect of competition (or the negative impact of market
power) on the bank liquidity position. We can interpret this effect by considering how bank
supervision may shape the liquidity incentives of banks with some degree of market power. In
general, financial intermediaries with larger pricing power may obtain more profits and then
wider cash flows. Because of that, they may have less need for short-term funding (implying
higher liquidity ratio) but also in the expectation of future cash flows they may decide to hold
smaller amounts of liquid assets (meaning lower liquidity ratio). Given these two effects,
stronger supervision may reinforce the incentives also of banks with some market power to
keep an appropriate amount of liquid assets, in such a way as to reduce the negative impact of
pricing power on the bank liquidity position.
Looking at the indicators in the National bank’s Survey, we can argue that higher
independence would strengthen the de facto effectiveness of banking supervision. Then, when
price competition among the incumbent banks is limited, an independent supervisor would be
able to ensure that such market power does not produce adverse consequences for bank
liquidity. For this reason, the independence of bank supervisors would provide a corrective
mechanism for banks with large market power to reduce the incentives for slack liquidity
management.
Finally, the presence of government-owned banks may affect the competition liquidity
nexus, particularly in Ethiopia, where governments have wide control of the banking system
(on average 24 percent of the total assets of the banking system are government owned). The
public ownership could also imply the willingness of the government to intervene in support
of a distressed bank by providing liquidity facilities; this might induce some moral hazard in
the liquidity management of government-owned banks. The evidence supports this
hypothesis. The negative effect of bank market power on liquidity position increases if the
fraction of government owned banks is larger.
Banks with large market power are even less incentivized to prudently manage their liquidity
if the government owns a large stake in the banking sector. In principle, this effect should
concern main the institutions which are actually government-owned, but it might also affect
other banks, if the presence of a large public stake in the banking sector raises expectations of
more public intervention in the event of bank distress.
C. Credit Risk
In this section the researcher investigated whether, and to what extent, price competition may
affect the credit risk of the banks’ asset portfolio. The empirical results suggest that an increase
in price competition that is, a decrease in the Lerner Index implies a rise in the ratio of
nonperforming loans to total credit. This means that banks with large market power also display
a lower rate of nonperforming loans, because they are less interested in taking additional risks,
given their profitability. Recalling the two arguments proposed in the discussion on credit risk,
and on the basis of our results, we can argue that when price competition increases and banks
reduce their lending rates, the effect of an increase in bank risk taking from the lender’s side
may be more relevant than the effect of a potential decrease in credit risk from the borrower’s
side.
In particular, if we look at the baseline specification from Table 7, we observe that a one
standard deviation decrease in the Lerner Index in other words, an increase in price competition
implies a rise in the rate of nonperforming loans by 1.6 percent. This would be a relevant
impact, provided that in our sample the rate of nonperforming loans has an average value of
10.3 percent with a standard deviation of 12.1 percent. The negative impact of competition on
credit quality is also confirmed when we consider, instead of the bank-level Lerner Index, the
country-average Lerner Index. Actually, price competition at the economy level can even have
a larger effect, given that a one-standard deviation decrease in the country-average Lerner Index
reduces the ratio of nonperforming loans by 3.2 percent.
To compare the effects of market power with market concentration, we also introduce as a
control variable the bank market share, computed as the ratio between the asset size of a bank
and the total assets of the banking system in the country. In this case, we observe that unlike
the results on solvency risk market share and market power have different effects on credit
risk. Whereas higher market power implies, on average, a better quality of the loan portfolio, a
larger market share is associated with a higher rate of nonperforming loans. In this respect,
market share may also be considered as a proxy of the systemic relevance of a bank. Thanks to
the implicit subsidy from public support, large banks may be induced to assume more risk
taking than small banks and can then provide riskier loans. A percentage point increase in the
bank market share implies a 0.26 percent rise in the rate of nonperforming loans.
Market dynamics may also significantly impact the role price competition has on credit
quality. If the entry into the banking market is substantially restricted by high denial of license
applications, the impact of market power on credit quality may be reversed. In particular, if
the fraction of denied applications is higher than 72 percent, an increase in market power
induces an opposite effect that is; arise in the ratio of nonperforming loans because banks
operating in a restricted market may be incentivized to increase risk-taking behavior. For this
reason, it is crucial to ensure enough market contestability by allowing entry to new banks,
subject to certain prudential requirements.
Bank balance sheet factors concerning bank profitability, funding liquidity and asset
composition may have a relevant effect on the rate of nonperforming loans. In particular, the
sources of bank funding may influence the credit quality of the loan portfolio by affecting the
screening and monitoring incentives of the lender. According to the idea of delegated
monitoring in banking (Diamond 1984), banks which are more reliant on funding from
wholesale markets are expected to be more selective about the credit quality of the borrowers,
because they know that the counterparties can easily withdraw their funds. On the other hand,
banks mostly funded through deposits, especially if they are protected by deposit insurance,
have less incentive to ensure the credit quality of their loan portfolios, because depositors are
not able, or not interested, in monitoring the bank with regard to its lending decisions. The
empirical results confirm this argument: an increase in the fraction of deposits over total
funding has a positive impact on the rate of nonperforming loans.
The composition of bank assets may also reflect some banks’ preferences in risk taking. The
ratio of government bond exposures to total assets may be considered as an inverse measure of
the bank risk appetite: the institutions which invest a larger part of their assets in government
bonds prefer to have a more balanced risk profile. Indeed, banks with a larger share of treasury
bonds over their total assets also display a lower rate of nonperforming loans, because they
also tend to be more conservative in their credit provision. Finally, bank profitability is a key
determinant of the credit quality of the loan portfolio: more profitable banks tend to provide
credit to less risky borrowers. In fact, a higher rate of return on average equity is associated
with a lower rate of nonperforming loans. This result is also consistent with the interpretation
of the positive effect of market power on credit quality in terms of risk-taking incentives for
bank lending.
In Table 8, the researcher investigated the role of bank regulation and supervision in the
relationship between price competition and credit risk. In this respect, the results obtained
for credit risk are qualitatively analogous to the outcomes observed for solvency risk.
Capital regulation plays a key role in determining the sign and the size of the competition
stability nexus. Based on the empirical results, we can argue that in the absence of solvency
requirements more competition would imply a higher quality of credit provision, as long as
banks are incentivized by market pressures to select the most creditworthy borrowers, so as to
reduce the credit risk of their loan portfolios. However, such market mechanism may not work
completely in a credit market with asymmetric information, where lenders may not be able to
perfectly screen borrowers. Also, if some banks have large market power at their disposal, they
may exploit that power to take on additional risks.
Then, the regression estimates show that capital regulation may be a useful tool for addressing
such market failures, to the extent it incentivizes banks to use the additional profits from their
market power to build appropriate capital buffers. Indeed, considering the coefficients for the
Lerner Index and for the interaction term, we observe that market power may have a positive
impact on credit quality if the country-level indicator of capital regulation is higher than a given
threshold (5.27), whereas the average value of such index for the banks in our sample is equal to
7. In this respect, capital regulation provides a key contribution to ensure that the exercise of
market power doesn’t imply any adverse consequences in terms of credit quality for the loan
portfolio.
Also the quality of prudential supervision may be relevant for the relationship between price
competition and credit risk. Provided that banks with low market power may provide credit to
more risky borrowers, either for profitability incentives or because unable to practice price
discrimination, the existence of a strong supervisory power may reduce the negative effect of
such risk taking on credit quality. In particular, an increase in the prerogatives of supervisory
authorities to take preventive and corrective actions reduces the negative effect of price
competition on credit quality. Indeed, a rise in the supervisory power from the minimum (5) to
the maximum value (15) decreases the effect of price competition on the nonperforming loans
ratio from 3.6 percent to
0.3 percent (almost no impact).
Finally, the presence of deposit insurance may affect the credit quality of the lending process,
by inducing some moral hazard in the decisions of all banks, irrespective of their market
power.
Indeed, if there is an explicit deposit insurance scheme, or if depositors are fully reimbursed in
the event of bank failure, all banks are incentivized to take risk to such an extent that the
relationship between price competition and credit risk is not significant anymore.
 CHAPTER FIVE
CONCLUSION AND RECOMMENDATION
5.1. CONCLUSIONS
This paper analyzes the effect of bank competition and financial stability for banks in the
selected commercial banks in Ethiopia. The banking system in this region presents some
specific peculiarities, given that it generally shows some low level of competition and
relatively high market concentration. At the same time, it has achieved a quite satisfactory
performance in terms of financial stability, as shown during the global financial crisis. Indeed,
in a comparison with other banking systems around the world, it displays a high level of bank
solvency, as well as large buffers of liquid assets with respect to deposits and short term
borrowings. Moreover, it presents relatively limited risk taking as indicated by the markedly
lower rate of nonperforming loans compared with financial sectors elsewhere.
Given this motivation, the researcher investigated how the nexus between competition and
stability works for the banks in Ethiopia. In particular, the researcher provided three main
contributions with respect to the previous literature. First, the researcher explored whether and
how competition may affect stability with regard to three different types of bank risk at the
institution level solvency, liquidity, and credit risk and we show that the heterogeneous effects
observed in the existing literature may be explained in terms of different types of risk.
Second, the researcher examined how market entry, bank regulation, and bank supervision
may shape, or change, the impact of competition on different sources of bank risk. Third, the
study whether competition may have different effects on stability for commercial banks and
the researcher find that this might be the case for funding liquidity, given the peculiar
business model of commercial banks, which are less reliant on wholesale funding.
The empirical results suggest that the effects of bank competition on stability may differ
depending on the type of risk. In particular, the researcher observed that competition has a
positive effect on bank liquidity, while it may have a potentially negative impact on solvency
and credit quality.
Price competition improves the liquidity position of a bank by inducing a self discipline
mechanism on the choice of bank funding sources. If banks are subject to strong competition,
they get lower profit margins and are then unable to afford costly funding sources; for this
reason, they prefer to keep larger buffers of liquid assets. Capital regulation may strengthen
the liquidity enhancing effect of price competition, while deposit insurance may reduce such
incentives.
Also, price competition may reduce bank profits and then imply a possibly negative effect
on solvency. In general, if banks pursue active management of their capital, they may
respond to a decrease in profitability by increasing their capital base so as to improve their
resilience. In such a case, competition may have a positive effect on bank solvency if the
increase in bank capital insufficiently large to compensate for the reduction in bank profits.
Then, a country’s regulatory framework may affect the incentives of banks in various ways.
On one hand, the presence of a deposit insurance scheme reduces the opportunity cost of a
potential insolvency for competitive banks and so the rationale for a capital increases. On
the other hand, prudential requirements may provide an effective mechanism for banks with
market power to safely manage their additional profit margins and increase their capital
buffers.
Price competition may increase the credit risk of the loan portfolio if banks are induced to
take on additional risks to improve their profitability. In such a case, the effect of an
increase in bank risk taking from the lender’s side would be more relevant than the effect of
a potential decrease in credit risk from the borrower’s side. As also observed for solvency,
capital regulation may provide the appropriate incentives for prudent management of banks
with market power.
The paper also suggests various policy implications for the design and implementation of
financial sector reforms in the Ethiopia, particularly in the area of market contestability.
Indeed, a reduction in competition may determine an increase in bank risk, particularly for
solvency and credit risk, if the market is heavily regulated by restrictions on activity or if
access is restricted by the frequent denial of license applications. In such cases, banks may be
incentivized to exploit their position in no contestable markets as a way of taking on
additional risks. For this reason, policy authorities may be interested in adopting reforms that
promote price competition among the incumbent banks in the regulated markets, and modify
and reduce those regulations which may create unnecessary restrictions to the contestability of
banking markets, if these are not justified by other major policy objectives.
In fact, in the cases where competition may induce some possible incentives for bank risk
 taking, a strong supervisory power may induce banks to adopt more appropriate risk
management in their lending, to avoid an excessive and risky expansion of credit just for
profitability considerations. Also, the reduction of the government stake in the financial sector
may reduce the moral hazard incentives of banks with large market power, which may
otherwise adopt imprudent management of their liquidity because of their reliance on support
from the public sector.

5.2. RECOMMENDATION
Based on the findings of the study, some recommendations are given below to enhance
competition in the banking industry and bring financial stability. Firstly, without competition,
banks are prone to inefficiency or they are able to earn excess returns through charging a wide
margin between deposit and lending rates. Besides, some viable projects may remain unfinanced
or financed only at excessive costs. If banks are strengthened by the gymnastics of competition,
the banking system would be stronger and more resilient to shocks. Therefore, it is apparent to
give due regard to efficiency objectives, which are mainly related to promoting competition, and
at the same time rectifying information asymmetry related problems. Secondly, relaxing entry
requirements for banks and creating legal framework for the establishment of niche banks is
important to enhance competition and to provide more choices to customers and thereby
enhancing societal welfare. The successful introduction of niche banks should coincide with the
introduction of a comprehensive deposit guarantee scheme which may assist in preventing niche
bank failures leading to contagion.
Thirdly, there should be an e-money directive enabling electronic transmission facilities by
suitably regulated institutions since such implementation may lessen the dependency on cash for
lower income earners and create healthy competition. Fourthly, one of the major intervention
areas to achieve the required competition is to design and implement competition policy in the
banking industry. Competition policy that can be seen as a forum of regulation intended to bring
about the best of laissez faire. Effective competition policy is, in economic terms, the consumers’
best friend. The newly designed competition policy should consider the prevailing economic
environment and all the pros and cons to arrive at optimal competition policy. The effort in this
regard should not focus on avoiding concentration, as concentration may not negatively correlate
with competitiveness, but rather on improving contestability to bring about effective
competition. Fifthly, there is also a need for strengthening the supervisory authority (NBE) and
improving the quality of information. It is likely that Ethiopia will join WTO and expected that it
allows foreign participation in the banking industry to some degree. NBE should be
understandably cautious in opening up to foreign banks with unfamiliar procedures and
potentially doubtful reputations. NBE is expected to grade the quality of foreign banks.
However, NBE’s supervisory capacity is not developed and it may be difficult to regulate these
technologically advanced foreign banks. Therefore, it is indispensable for the NBE to prepare
itself to monitor and supervise foreign banks proficiently in order to minimize adverse effects in
an environment hitherto unfamiliar to it.
Sixthly, the Credit Information Center (CIC) in the NBE should be strengthened with appropriate
manpower and information technology facilities to rectify the problems associated with
information asymmetries and to provide timely and reliable information exchange among banks
about borrowers. Seventhly, there is a need to structurally strengthen the NBE by establishing or
assigning an organ that regularly follows up competitive conditions over time, and be aware of
the extent of the prevailing competition aiming at maintaining stability and efficiency. This
organ is assumed to regularly evaluate the pros and cons of competition and suggest how optimal
competitive environment will be achieved.
Thirdly, there should be an e-money directive enabling electronic transmission facilities by
suitably regulated institutions since such implementation may lessen the dependency on cash for
lower income earners and create healthy competition. Fourthly, one of the major intervention
areas to achieve the required competition is to design and implement competition policy in the
banking industry. Competition policy that can be seen as a forum of regulation intended to bring
about the best of laissez faire. Effective competition policy is, in economic terms, the consumers’
best friend. The newly designed competition policy should consider the prevailing economic
environment and all the pros and cons to arrive at optimal competition policy. The effort in this
regard should not focus on avoiding concentration, as concentration may not negatively correlate
with competitiveness, but rather on improving contestability to bring about effective
competition. Fifthly, there is also a need for strengthening the supervisory authority (NBE) and
improving the quality of information. It is likely that Ethiopia will join WTO and expected that it
allows foreign participation in the banking industry to some degree. NBE should be
understandably cautious in opening up to foreign banks with unfamiliar procedures and
potentially doubtful reputations. NBE is expected to grade the quality of foreign banks.
However, NBE’s supervisory capacity is not developed and it may be difficult to regulate these
technologically advanced foreign banks. Therefore, it is indispensable for the NBE to prepare
itself to monitor and supervise foreign banks proficiently in order to minimize adverse effects in
an environment hitherto unfamiliar to it.
Sixthly, the Credit Information Center (CIC) in the NBE should be strengthened with appropriate
manpower and information technology facilities to rectify the problems associated with
information asymmetries and to provide timely and reliable information exchange among banks
about borrowers. Seventhly, there is a need to structurally strengthen the NBE by establishing or
assigning an organ that regularly follows up competitive conditions over time, and be aware of
the extent of the prevailing competition aiming at maintaining stability and efficiency. This
organ is assumed to regularly evaluate the pros and cons of competition and suggest how optimal
competitive environment will be achieved.
Development of competitive information system will be also a function of this organ. It also
suggests as to how to relax regulation and update competition policy to make competition
effective without compromising the stability objective. Finally, there need to prepare fertile
grounds to opening up a capital market. Opening up a capital market may bring about additional
options of investment for savers, which may strengthen competition.
As a final note, all the concerned bodies including central bank of Ethiopia need to understand
the competition level of banking industry in Ethiopia in order to scale up and strengthen financial
sector development. It is also important take a lesson from other developing countries and adapts
important practices of financial sector into Ethiopian economy.
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 APPENDIX

Table1: Sources and Description of the Variables

Independent Variable- Competition DESCRIPTION
Lerner Index Itisameasureofthemarketpowerofabank.Itiscomputedastheratiobetweenthebank mark-up (price–
marginal cost) and the average price of bank assets.
Market Share The ratio of the total assets of a bank to the total assets of all the banks in a given country.
Higher value means larger market share of a bank with respect to its domestic market.
Capital Regulation The stringency of capital requirements, with in arrange between 0 and 10. Higher value means
more stringent regulation.
Supervisory Power The power of supervisory authorities to take specific actions to prevent and correct problems,
within arrange between 0 and 15. Higher value means stronger supervisory power.
Deposit Insurance Scheme Whether there is an explicit deposit insurance scheme and depositors were fully compensated
the last time a bank failed. It is equal to 0 in presence of insurance and to1 in absence of that.

Dependent Variable- Financial Stability

Bank Solvency
Z-Score It is a measure of the distance of a bank from insolvency. It is computed as the sum of the
equity-asset ratio and of the return on assets (RoA), divided by the standard deviation of the
RoA. Higher value means better solvency of a bank.
Equity Asset Ratio The ratio between total equity and total assets
Return on Average Assets The ratio of bank net income to the average value of assets

Bank Liquidity

Credit Risk
Non-Performing Loans Ratio The ratio between non-performing loans and total loans
 Table2: Summary Statistics
Variable Bank competition Obs Mean Std.Dev. Min Max

Lerner Index 17 .3257241 .349005 -1.80814 1.792211

Bank Market Share 17 .0917404 .1346114 .000185 1

Bank solvency
17 9.731529 18.8839 -29.59916 241.604
Bank Z-Score
Country Average Z-Score 17 1.753135 .5518894 -1.167987 3.238249
Weighted Average Z-Score 17 17.17372 15.63936 -1.167987 67.4677
Tot Regulatory Capital Ratio 17 22.04591 13.56645 8.05 92

Bank credit risk

17 .1032941 .1214676 .0012 .683
Non-Performing Loans Ratio
Loan Loss Provisions to Interest 17 .2716322 .4864896 -.6169 3.1066
Revenues

Bank liquidity
Deposit to Total Funding Ratio 17 .8104914 .2161244 .0416 1
Liquid Assets/Short-Term 17 .4705926 .4017674 .0364 2.6928
Borrowing Ratio
Table 3: The Effects of Bank Competition and of Market Entry on Solvency Risk
2016 2017 2018 2019 2020 2021
VARIABLES Z-Score Z-Score Z-Score Z-Score Z-Score Z-Score
Lerner 0.134*** 0.136*** 0.302*** -0.355* 0.218**

Average Lerner 0.293***

Market Share 0.706**
Lerner *Activity Restrictions -0.0241**
Lerner *Entry Requirements 0.0611***
Lerner *Denied Applications -0.255*
Loans Assets Ratio 0.122 0.225* 0.161 0.0588 -0.0206 -0.217
Government Bond Ratio 0.256** 0.214* 0.247** 0.268** 0.322*** 0.299
Deposit Funding Ratio 0.130 0.166 0.132 0.141 0.139 0.686***
Non-Interest Income Ratio 0.321** 0.149 0.337** 0.146 0.222* 0.153
Growth Assets -0.125** -0.0924* -0.140** -0.0756 -0.0910* -0.0591
Non-Performing Loans Ratio -0.251** -0.209* -0.251** -0.293** -0.294** -0.312
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<0.1
Table 4: The Effects of Bank Competition and of Bank Regulation and Supervision on Solvency Risk
2016 2017 2018 2019 2020 2021
VARIABLES Z-Score Z-Score Z-Score Z-Score Z-Score Z-Score

Lerner Index 0.134*** -0.508*** 0.313** -0.0898 0.148*** 0.0253

Lerner *Capital Regulation 0.0823***
Lerner *Supervisory Power -0.0157
Lerner * Supervisory Independence 0.102***
Lerner *No Deposit Insurance -0.125**
Loans Assets Ratio 0.122 -0.131 0.0757 0.00647 -0.113 -0.194
Government Bond Ratio 0.256** 0.308*** 0.270** 0.354*** 0.279** -0.0256
Deposit Funding Ratio 0.130 0.147 0.237* 0.0428 0.110 0.0551
Non-Interest Income Ratio 0.321** 0.239* 0.214 0.260* 0.192 0.0572
Non-Performing Loans Ratio -0.251** -0.291** -0.237* -0.300** -0.413*** -0.503***
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<0.1
Table 5: The Effects of Bank Competition and of Market Entry on Liquidity Risk
2016 2017 2018 2019 2020 2021
VARIABLES Liq Ratio Liq Ratio Liq Ratio Liq Ratio Liq Ratio Liq Ratio
Lerner -0.106*** -0.104*** 0.0379 0.256** -0.00829

Average Lerner -0.299***

Market Share 0.250*
Lerner *Activity Restrictions -0.0204***
Lerner *Entry Requirements -0.0456***
Lerner *Denied Applications 0.0555
Loans Assets Ratio -0.643*** -0.571*** -0.634*** -0.652*** -0.594*** -0.199**
Non-Interest Income Ratio -0.175*** -0.157*** -0.164*** -0.121* -0.166*** -0.138*
Return on Average Equity 0.205*** 0.148*** 0.197*** 0.192*** 0.150*** 0.0371
Growth Assets 0.0146 0.0323 0.0113 0.00907 0.0171 -0.00414
Non-Performing Loans Ratio 0.352*** 0.276*** 0.345*** 0.339*** 0.342*** 0.253***
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<0.
Table 6: The Effects of Bank Competition and of Bank Regulation and Supervision on Liquidity Risk
2016 2017 2018 2019 2020 2021
VARIABLES Liq Ratio Liq Ratio Liq Ratio Liq Ratio Liq Ratio Liq Ratio
Lerner -0.106*** 0.0411 -0.171** -0.193*** -0.0434 0.0510

Lerner *Capital Regulation -0.0188**

Lerner *Supervisory Power 0.00577
Lerner * Supervisory Independence 0.0394***
Lerner *No Deposit Insurance -0.0843***
Lerner *Government Owned Banks -0.00885***
Loans Assets Ratio -0.643*** -0.635*** -0.673*** -0.667*** -0.621*** -0.595***
Non-Interest Income Ratio -0.175*** -0.0875 -0.116* -0.183** -0.147** 0.00943
Return on Average Equity 0.205*** 0.149** 0.151*** 0.216*** 0.167*** 0.0839
Growth Assets 0.0146 0.00631 0.0115 0.00414 -0.00139 0.0195
Non-Performing Loans Ratio 0.352*** 0.337*** 0.315*** 0.389*** 0.353*** 0.375***
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<0.1
 Table 7: The Effects of Bank Competition and of Market Entry on Credit Risk
2016 2017 2018 2019 2020 2021
VARIABLES NPL Ratio NPL Ratio NPL Ratio NPL Ratio NPL Ratio NPL Ratio
Lerner_1 -0.0462*** -0.0442*** -0.0617** -0.0357 -0.0791***

Average Lerner -0.127***

Market Share 0.262**
Lerner *Activity Restrictions 0.00256
Lerner *Entry Requirements -0.00131
Deposit Funding Ratio 0.121*** 0.113*** 0.124*** 0.139*** 0.128*** 0.150**
Return on Average Equity -0.241*** -0.260*** -0.245*** -0.252*** -0.251*** -0.0868
Government Bond Ratio -0.0766** -0.0649** -0.0822** -0.0914*** -0.0822** -0.179***
Growth Assets -0.0242 -0.0140 -0.0279* -0.0300 -0.0249 -0.0456**
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<0.1
Table 8: The Effects of Bank Competition and of Bank Regulation and Supervision on Credit Risk
2016 2017 2018 2019 2020 2021
Variables NPL Ratio NPL Ratio NPL Ratio NPL Ratio NPL Ratio NPL Ratio
Lerner -0.0462*** 0.0807* -0.151*** -0.0342 -0.0230 -0.0269

Lerner *Capital Regulation -0.0153***

Lerner *Supervisory Power 0.00944**
Lerner * Supervisory Independence -0.00176
Lerner *No Deposit Insurance -0.0377*
Lerner *Government Owned Banks 0.000125
Deposit Funding Ratio 0.121*** 0.139*** 0.129*** 0.189*** 0.141*** 0.0740
Return on Average Equity -0.241*** -0.276*** -0.271*** -0.271*** -0.264*** -0.239***
Government Bond Ratio -0.0766** -0.0977*** -0.0972*** -0.0708* -0.0951*** 0.0607
Standard errors in parentheses: *** p<0.01, **p<0.05,* p<