Competition and financial stability Essay Example | Topics and Well Written Essays - 2000 words

Competition and financial stability - Essay Example The competition is always seen as a requirement necessary for efficiency of the banking system. Although varied theoretical and empirical studies have attempted to argue that monopoly offer banks higher incentives to improve their financial performance, competition in the banking sector have also enabled banks to compete favorably; thus enabling banks to achieve their demanding needs effectively (Schinasi and International Monetary Fund, 2006). This is because of the notion that vulnerability and restraints on competition are necessary for preserving the stability of the banking system in the current financial market; therefore, the essay offers a critical assessment of the trade-offs between competition in the banking system and financial stability. Advantages of Competition Competition is desirable in the banking system because it contributes to increased competitive business performance across the banking sector (Marinc, 2012). The charter-value for competition stability theory as sumes that the more concentrated and less competitive banking systems, the higher chances of becoming more stable. The contrasting perspective to this theory is that a more concentrated banking structure may lead to more bank frailty. Boyd, De Nicolo and Jalal (2010) argue that market control in banking system increases profits, but bank steadiness ignores the prospective impact of market powers for banks. The authors argue that the higher interest rates in the banking sector may induce the banking industries to assume greater risks; hence, they find a positive relationship between concentration and bank fragility (Kohn, 2003). Many banking system support competition feebleness and this had significantly contributed to financial volatility in many banks across Canada and the UK. Therefore, the less bank rivalry, the less credit rationing and higher chance of malfunction in case loans are subjected to multiplicative reservations. Competition and higher level of concentration in the b anking sector can also create a positive impact on liability menace. Boyd, De, Jalal and International Monetary Fund (2009) argue that less competition in banking system can contribute to more financial stability in case information about the probability distribution of liquidity of the depositor is private. Allen, Carletti, Gale and Centre for Economic Policy Research (2011) assert that it is crucial to prevent banks from taking excessive risks in the competitive markets. Hence, the deposit interest rate ceilings are vital even with capital requirements. Beck, Beck and World Bank (2008) argues that concentration is not a consistent rivalry signal in the banking sector; thus, the bank illiquidity can augment in any fiscal market structure. Therefore, lower competition in the banking system is crucial because it enables banking relationships to endure for a long period. Drawbacks of Competition Competition in the financial market can impact steadiness in the banking system in diverse ways; first, competition can impact financial stability is through the interbank market system and through the payment system channels. Allen and Gale (2000) argue that perfect competition can prevent banks from offering liquidity to other banks that have been strike by short-term liquidity shortage. Therefore, there is no bank that will have adequate incentive to offer liquidity to the banks that have problems in case all banks are price takers.