In this project I examine the effect of competition on the level of risk in the banking sector. It is highly relevant to understand this effect because a crisis in the banking sector has many harmful consequences for the real economy; however a high level of competition is usually regarded as beneficial for the economy. So if a higher level of competition makes banking crises more likely, it points to a regulatory dilemma. In order to solve this dilemma it is necessary to understand the interaction between risk and competition. In order to understand the above mentioned interaction I undertake theoretical and empirical investigations. From the theoretical analysis it follows that banks will increase their risk level as a response to increased competition (in the market for deposits) if it leads to a higher spread of interest rate. However it is only in a limited number of scenarios that it is possible for banks to increase this spread without costs. If the public have knowledge of the banks risk, if there are bankruptcy costs or competition in the loan market it is impossible for banks to increase the spread. Further the exact direction and size of the effect are also dependent on whether or not the theoretical model includes product differentiation. In the empirical investigations I check whether the level of competition (measured with both the Lerner-index and HHI) affects three different risk indicators. As risk indicators I use capital ratio, CDS prices and survey answers (banks were asked by the ECB whether they had tightened or eased their credit standards). Only the capital ratio is influenced by changes in the level of competition: An increase in competition leads to a lower capital ratio and hence increased risk. However neither the CDS prices nor the survey answers are influenced by changes in the level of competition. So even if the level of competition has an effect on solvency, it neither affects the credit standards of banks nor the markets perception of the riskiness of banks. The result attained in this project is that the level of competition in general does not have a clear effect on the riskiness of banks. The size and the direction of the effect are dependent on the regulatory and competitive framework.
|Educations||MSc in Mathematics , (Graduate Programme) Final Thesis|
|Number of pages||108|