Bank Competition and Bank Supervision

Speech by Ignazio Angeloni, Member of the ECB Supervisory Board,
at CaixaBank,
Barcelona, 4 July 2016

1. Introduction^[1]

It is a pleasure to be here today and to deliver this CaixaBank lecture. I am grateful to the organisers of this event for inviting me.

This lecture series bears witness to the long standing commitment of the Caixa group to the enhancement of knowledge. Indeed, it has been a hallmark of this institution to unite the pursuit of banking business with goals in the social sphere. This trait – to combine private and collective interest – is not unique; for example, it is part of the historical heritage of savings banks. I elaborated on this point two years ago in a conference in Madrid where I discussed the strengths and the weaknesses of savings banks model in the European banking landscape.

Today I would like to bring the argument one step further: I will suggest that combining the private and collective function is to some extent rooted in the essence of every bank, regardless of its business or governance model. The reason is grounded in the nature of the products that banks offer: on their liability side, liquidity and means of payments; on the asset side, credit and, again, liquidity. The attributes of liquidity are immediacy and certainty. In a world that, by nature, is not liquid, because economic activity takes time and is risky, banks perform the magic – the “alchemy”, as Mervyn King has recently called it^[2] – of creating liquidity out of illiquid assets. Payments technologies are essential to the working of every economy; banks ultimately guarantee, together with the central bank, the finality of every payment. Finally, credit, especially if we read in this word its Latin etymology of “trust”, is needed in every economy – except perhaps that of Robinson Crusoe – for igniting the engine of investment and growth. Liquidity, payments and credit are essentially public goods, as is the stability of the environment in which they are provided. Yet, they are produced by institutions that are privately owned and managed. The starting point for approaching most questions regarding banking policies, from regulation to supervision, from resolution to safety nets, up to competition and transparency rules, is to recognise this double nature and its implications.

The goal of every private firm is to successfully compete on the market. Competing means doing better than others and eventually prevailing, possibly driving them out of business or acquiring them. From Schumpeter onwards, “creative destruction” has been regarded as a fundamental engine of economic development. Does the same notion apply to banking? The answer is not easy. Schumpeter himself did not explicitly make this inference, nor is it reported that, when he was finance minister of Austria after the Great War, he did much to change the anti-competitive banking rules of his country. Recently, scholars have made partly conflicting arguments. Some have noted that insolvent credit institutions (the so-called “zombie banks”), if allowed to remain in the market, can be a factor behind the prolongation of economic recessions.^[3] Others have argued that competition works differently in banking, because unlike in other economic sectors, the failure of a significant bank can damage its competitors and possibly lead to chain reactions and systemic instability. In the post-war experience, phases of financial liberalisation have often been followed by financial crises.^[4]

Socially beneficial competition requires rules to ensure fair behaviour and a level playing field. It is generally considered best practice to entrust the enforcement of these rules to independent authorities. Should the same rules apply to banks, and should the same authority be in charge of competition in all sectors? Institutional arrangements vary. An international survey by the Basel Committee on Banking Supervision showed that in around 35% of cases, prudential authorities also have competence on bank competition.^[5] Diversity reflects pros and cons and trade-offs in different arrangements; country-specific conditions, cultures and traditions also matter. The European Union (EU) represents a unique case. All Member States have national competition authorities, variously engaged in the financial sector as well. In addition, the EU Treaty assigns to the Commission the function of competition authority, including State aid control, without distinction among economic sectors. Given the specific political and institutional features of the Union, State aid control has been used by the Commission to prevent national authorities from granting unfair advantage to domestic producers. The Commission has typically sought to guard against protectionist behaviour by Member States, including, in the case of banking, national supervisors and regulators.

The establishment of the banking union changes the context. First, the traditional mission of preventing Member States from defending their “national champions” becomes less relevant, at least within the banking union. Both the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) are designed to pursue the interest of the Union as a whole (not, it should be noted, of their participating Member States only). It remains possible, of course, that Member States attempt to propel domestic banks in other ways, in spite of the presence of the new EU authorities. Second, the Commission’s presence becomes even more important in contrasting anti-competitive behaviour by market participants, both within the banking union area, where single market forces are enhanced by the presence of a more effective single rulebook, and between banking union members and non-participating members. Finally the existence of new banking authorities suggests that new rules of engagement and cooperation should be established. This is particularly important in the area of crisis management, where financial stability concerns may require public intervention.

My goal today is to present some arguments and evidence that can help shed light on these issues. I will not go as far as to provide complete answers, let alone firm policy prescriptions. The issues involved, very complex in themselves, are further complicated by the fact that the banking landscape is evolving rapidly, as a result of market forces (bank competition and consolidation) and institutional changes (new regulation, the banking union). Last in time, Brexit has the potential, going forward, to redesign the competitive patterns of European banking, depending on the future relations between the City of London and the EU Single Market.

I will start with a short review of recent economic literature on the links between competition and financial stability, and the role of regulation and supervision. This will be followed by a brief overview of the institutional arrangements regarding competition and State aid control in the United States and Europe. Then I will present some data, showing in particular how certain basic measures of bank concentration and competition in banking have evolved recently. Finally, I will bring these elements together and offer some concluding reflections on how competition and State aid control can best be combined in the context of the banking union.

2. Bank competition and stability: a conceptual review

We should bear in mind at the outset that fragility and risk are inherent features of banks that depend on the function they perform as credit and liquidity providers. Such fragility exists irrespective of whether competition within the sector is strong or weak. It depends on the structure of the balance sheet – the matching of short and long maturity, of liquid and illiquid instruments ­– and not on the fact that banks compete with one another.

That being said, competition in banking has often been seen with some suspicion, as a factor that may lead or contribute to financial instability. Among economists, the interaction between competition and stability in banking has been a controversial subject for many years. This controversy has not been conclusive: results are typically sensitive to theoretical assumptions, different risk measures, competition proxies, and the characteristics of the data used.^[6]

Let’s examine the issue in some more detail, on both sides of the bank balance sheet.^[7]

On the liability side, banks finance themselves by raising short-term funds: demand deposits and, increasingly in recent years, short-term uninsured instruments like short-term certificates of deposit (CDs), asset-backed commercial paper, or repurchase agreements (repos). This creates a coordination problem among creditors, which may give rise to bank runs.^[8] Competition enters the picture in two ways. First, to the extent that competition for funds induces banks to offer ever-shorter maturities to meet their creditors’ demand, it increases the maturity mismatch and the risk of a run.^[9] Second, by lowering bank profits competition may reduce the buffers in the banks’ balance sheets and make bank failures more likely.^[10] This may affect also the system as a whole, potentially giving rise to systemic crises.

Problems on the asset side can arise as a consequence of banks’ excessive risk-taking. This depends on the fact that bank shareholders and managers do not fully bear the costs of potential failures and are difficult to monitor and supervise.^[11] The prevailing view has been that competition exacerbates risk-taking. According to the charter-value hypothesis, banks tend to protect their charter value by holding excess capital.^[12] Competition erodes charter values and reduces this incentive towards prudence. Risk-taking and defaults become more likely as the competitive pressure increases.^[13]

Some authors have also made the opposite argument, namely that competition may mitigate systemic risk.^[14] All in all, however, the evidence is tilted towards suggesting that, in most realistic circumstances, if left unchecked bank competition can endanger financial stability. Further support is provided by the episodes of financial instability that followed the wave of deregulation and liberalisation in the US and other major industrialised countries in the 1970s. In the US, and also in Japan and the Scandinavian countries, the removal of restrictions on banks’ activities, interest rate ceilings, and limitations to the geographical scope of banks’ operations resulted in a more competitive environment and was followed by an increase in the number of bank failures.^[15]

The question for the policy maker is: what can be done? Efficiency and stability are both socially valuable goals. Outright limits like those common in the 1970s, like interest rate caps, barriers to entry, limits to branches, credit ceilings, and so on, may have made the system more stable for a while, but entailed costs in terms of efficiency and quality of bank services. In the longer run, financial repression can even generate fragility, because it creates economic distortions and imbalances and because it can have destabilising effects when it is reversed.

One alternative is to design regulatory and supervisory frameworks that discipline banks without constraining competition. This notion has gained consensus in recent years. For example, Xavier Vives argues, in his forthcoming book on “Competition and Stability in Banking”, that “[…] the trade-off between competition and stability arises due to regulatory imperfections or outright regulatory failure […]”.^[16] This means trying to shift the trade-off outwards, making the system more competitive and more stable at the same time.

Empirical analyses have confirmed that differences in the regulatory framework explain the cross-country variations in the relationship between competition and stability.^[17] The experiences of crises in Japan and the Nordic countries in the 1990s support the role of regulation in shaping the competition-stability nexus. These crises followed an intense process of deregulation and liberalisation that was not accompanied by a regulatory reform. The crisis of the Saving and Loans Associations in the US is another example. While high interest rates triggered defaults in the early 1980s, the real crisis came later, as a consequence of a prudential framework that relied increasingly on forbearance and deregulation.^[18] Recent theoretical work supports the idea that higher competitive pressure needs to be upheld by stronger prudential requirements.^[19]

These considerations also suggest that competition and prudential control need to liaise closely. Together, supervision and competition authorities can help ensure that financial stability risks are minimised while the efficiency gains associated with competition are preserved.

3. Overview of institutional arrangements^[20]

Let’s now turn to how competition control and prudential supervision interact in practice. I will consider only the cases of the United States (US) and the European Union, though other examples are of interest as well.^[21]

In the US, the basic body of antitrust legislation, the Sherman Act, dating back to 1890, combats abuse of monopoly power by making contracts and practices that restrain or monopolise trade or commerce illegal. In the US, antitrust actions are initiated by the Department of Justice (DoJ) and the Federal Trade Commission (FTC), as well as by private parties and the States.

There are three main elements that emerge from the US experience.

First, while in principle banking is treated like any other activity, Congress and the Supreme Court have recognised that there are circumstances where antitrust law need to be relaxed for financial stability reasons. Certain banking activities have been deemed to affect the balance between stability and competition, and in those cases deviations from the otherwise prevailing standards are accepted.

Second, in enforcing competition rules in banking, the supervisory authorities are in charge or at least involved. Specifically, mergers and acquisitions by banks and bank holding companies have been insulated from the full reach of the country’s antitrust laws, when they help promote collective well-being by fostering or preserving financial stability. Such circumstances are assessed by the banking supervisors.^[22] Mergers, consolidations and asset or deposit acquisitions by an insured depository institution require the approval of the supervisory agency (the Comptroller of the Currency, the Federal Reserve or the FDIC, depending on their respective competence). In practice, the control of mergers and acquisitions is performed largely by the Federal Reserve.^[23] The supervisor would not approve a merger resulting in a monopoly, or whose effect may substantially lessen competition, unless it found that the anticompetitive effect of the transaction is clearly outweighed, in the public interest, by gains for the stability of the financial system.

The third important element that emerges from the US experience is that public support to banks to maintain financial stability is excluded from the scope of competition control. The Sherman Act does not restrain actions directed by the public sector in a regulatory capacity, even if those actions would violate the Act if performed by others. The Federal Reserve System is not subject to the Sherman Act, notwithstanding the private shareholder structure of its regional Reserve Banks. US States imposing anticompetitive restraints as an act of government are accorded immunity from antitrust liability. All guarantees, recapitalisation and impaired asset measures of the US Government and the emergency facilities of the Fed during the financial crisis were free from constraints under US antitrust laws.

Let us now turn to the EU. Competition law is a cornerstone of the Union; according to the Treaty, economic policy is to be conducted in accordance with the principle of an open market economy with free competition. Rules ensure that competition in the internal market is not distorted, for example by cartels, restrictive practices and abuse of a dominant position, as well as State aid. While the provisions on private practices like cartels, abuses of a dominant position and so on echo those prevailing in other advanced economies, the notion of controlling State aid by law is unique to the EU. As already mentioned, this can be explained by the fact that the Union is composed of a plurality of potentially competing countries.

There are no special treatments or exceptions for banks under EU competition law. Extensive European case law has built up regarding the application of competition rules to the banking industry. Specifically, in the area of merger control^[24] the Commission, subject to review by the Court of Justice, has sole jurisdiction to approve, attach conditions to or block concentrations with a Community dimension. Member States may take appropriate measures to protect their legitimate interests, including prudential rules. The application of this prudential carve-out has generated controversy in a number of cases, where there have been allegations that national prudential authorities have used their powers to advance national interests by blocking takeovers initiated by foreign banks. In the SSM, the ECB as prudential authority has the power to authorise the acquisition of qualifying holdings in banks. A prudential carve-out exists also for mergers – though it is still unclear whether this power is exercised by the ECB or the national supervisory authorities.

Starting from the financial crisis, the Commission has established a framework for coordinated State aid in support of the financial sector. This framework was developed in a series of “Crisis Communications” (2008-13). The 2013 Communication, in particular, marks a turn in the direction of a more restrictive approach, with much tighter conditions, including burden-sharing, partly intended to help a smooth transition to the Bank Recovery and Resolution Directive (BRRD), which entered into force between 2015 and 2016 with even stricter rules. Under the BRRD, resolution action is taken if a bank is deemed failing or likely to fail, which happens, inter alia, when public support is provided. There are only specific and restrictive exceptions to this rule. Once resolution is started, burden sharing (bail-in) rules apply. Creditors potentially involved include, in addition to shareholders and subordinate debt holders, senior bond holders as well as depositors. Limited exceptions are contemplated, in particular for insured deposits; secured liabilities; very short-term (7-day) interbank deposits, settlement system and clearing house exposures; and a few others items that are critical to preserve operational functions of the bank. A “no-creditor-worse-off” rule does hold, meaning that no creditor should incur greater losses than it would under normal insolvency proceedings, but other than that, only very specific and restrictive exceptions apply.

4. Recent developments in the euro area

The attached slides illustrate some recent evidence on the issues discussed here. The indicators cover, specifically, bank concentration and integration in the euro area before and after the crisis, as well as the amounts of State aid and the decisions taken by the EU’s State aid and competition authority.

Chart 1 presents two standard bank concentration measures for the euro area and the EU: the market share of the largest 5 banking institutions and the Herfindhal index. Both measures point to a significant and steady increase in bank concentration in the last 10 years. The trend seems to have accelerated during the most acute phases of the financial crisis in the euro area.

Chart 2 dissects these movements by comparing the values of the Herfindhal index before the crisis (2007) and after (2014), distinguishing two groups of countries: those that have undergone an adjustment programme supported by the international community (EU and IMF) and the other countries. The average patterns for the two groups of countries are highlighted by lines that interpolate the relevant points. The evidence suggests that the increase in concentration between the two years is greater for the countries that have undergone an adjustment programme. This is due, at least in part, to the fact that the programmes have included interventions on banks that have increased, e.g. via mergers or resolution, the concentration of the market.

In Chart 3, the data for the 4 largest euro area countries are shown. This chart illustrates the fact that the trend towards concentration visible in the euro area also occurs within each country (where the relevant market is the national one, not that of the area as a whole). The only exception is France, where bank concentration declines between 2008 and 2013 (but rises thereafter).

It should be noted that bank concentration is, at best, an imperfect proxy of bank competition. Markets can be competitive, even if relatively concentrated, if they are “contestable”, that is, competitive pressure can be exercised also by outsiders. This happens when entry and sunk costs are sufficiently low.^[25] For this reason, it is important to combine the concentration indicators with other measures, notably focused price performance. We will see evidence on this in a moment.

Chart 4 shows the evolution of the number of banks, in the euro area and the EU. We see that that number has been on a steady declining trend for the last decade at least. This evidence matches that of Chart 5, which shows the volume of bank assets as a ratio to GDP in the 4 largest euro area banks and in the area as a whole. It is clear that the size of the banking sector has declined in the area, but we can also see that the phenomenon is not taking place everywhere. In particular, Germany, the country characterised by the largest values in the mid-2000s – both in terms of the number of banks and their overall size – is the country where the decline is most evident. A recent report by the ESRB^[26] concluded that the EU banking system is “overbanked”, i.e. characterised by an excessive number and size of banks. It is interesting to see, however, that the differences in the degree of “overbanking” do not match the relative speed of decline of the banking sectors across countries.

Chart 6 shows the leverage ratios of the major banking sectors, again for the four largest euro area countries and for the whole area. This information tells us whether the decline in bank size (measured by the total scale of the balance sheet) has occurred in parallel with the decline in the volume of capital. Interestingly, the chart shows that the most pronounced decline occurred in Germany, which is also the country where the banking sector’s size is declining most rapidly.

In Chart 7, banking integration is measured by the size and number of merger operations. There was a clear increase in the number, and especially the size, of mergers in the years preceding the crisis, a feature mentioned repeatedly in the ECB’s Financial Integration Report. After the crisis, merger activity waned, especially among large banks and across borders.

Chart 8 shows the cross-country dispersion of bank lending interest rates (short-term, floating rate). For the reason already explained, it is useful to combine this type of evidence with that on bank concentration. We see that the dispersion was on a declining trend before the crisis, prima-facie sign that the increasing bank concentration that was taking place at that time had not reduced the contestability of the respective markets. After the crisis, the dispersion of rates increased drastically, to decline only after 2013. This evidence points to a segmentation of bank credit markets during the most acute phase of the crisis, when bank concentration was increasing further. This seems consistent with the view that the degree of competition in the loan market declined in the post-crisis years.

Finally, the two tables at the end provide evidence on State aid and on the activity of the Commission in the area of competition and State aid control. Table 1 shows the amounts of public financial support provided to banks in the 2008-13 period, relative to GDP and to the size of public debt. Among the larger countries, sizeable aid volumes were provided in Spain and Germany; this was much less the case in Italy and France. The small programme countries provided much higher relative volumes of aid in relation to their GDP. The size of State aid in the UK in the period was higher than the euro area average (over 6% of GDP, as opposed to around 5%).

Table 2 collects data on the number of decisions adopted by the EU Commission (competition authority) over the 2010-15 period. This information comes from the website of the Commission’s Directorate-General Competition (DG Comp), which contains a rich set of information on the activity of DG Comp in its areas of competence. Looking at the period as a whole, we note that most decisions were adopted in the non-financial sector, as one would expect. More surprising is the share of decisions adopted on State aid, as opposed to the other areas of competence (cartels/antitrust and mergers). In the financial sector, that share is 68.7%; it was significantly higher in the initial years of the sample, coinciding with the euro sovereign crisis. For the non-financial sector, the share is lower (62.6%) and there does not seem to be a noticeable decline. Although the interpretation of these data is not unambiguous (a high number of decisions, which normally are adopted in order to authorise State aid, can be interpreted as signalling either a restrictive or a liberal policy stance), the evidence is nonetheless interesting in that it signals the intensity of the Commission’s activity in this area, in contrast with the U.S. case.

5. Conclusions

I realise that my remarks have departed somewhat from a usual “lecture”, the format that the title may have led to expect. But I think this is appropriate. Banking supervisors should not lecture their audiences, even less the banking industry. They should rather exchange and compare ideas with the aim of identifying sound, if possible consensus-based, policy solutions. In the same vein, let me put forward some summarising and concluding ideas.

First, as the banking union develops and the industry adjusts to it, I expect the role and the importance of the EU competition control authority to grow. In the early phases of the crisis, this authority made a fundamental contribution, in the absence of an area-wide supervisory and resolution authority, in organising bank rescue and restructuring operations while keeping the taxpayers’ burden under control. But that role was somewhat limited, focused as it was on the particular angle of State aid control. Going forward, the challenge will be greater. Restructuring and consolidation in euro area banking will continue and in fact intensify, as we move away, hopefully not too far in the future, from crisis conditions. Banking integration will resume, domestically and across borders. Overbanking will decline further, as is already happening, in some countries in particular. Competition forces will become more intense. Financial technology, which may be on the verge of a further leap forward, will play a significant part. Brexit could be another factor. In this challenging environment, there will be a need for a European authority firmly focused on guiding and monitoring the process, with constant attention on the evolution of banking structures – area-wide, national, local – and of the relevant markets.

Second, the State aid control function, while remaining important, will need to be redefined. State intervention within the banking union retains the potential of distorting the playing field in many important and harmful ways. But this potential is lower than in the past, being more effectively counterbalanced by regulation and especially by European authorities for supervision and resolution firmly anchored to a pan-European mandate. Moreover, it should be clear that public support, properly regulated and controlled, is a fundamental component of a well-structured banking framework. This notion has, in my view, been somewhat lost in some recent debates. A role for the public sector is justified on conceptual grounds. It is present in the other major jurisdictions with which we compare ourselves and compete, starting with the US. In fact, the existing European legislation, including the Bank Recovery and Resolution Directive and the Commission communication of 2013, provide safeguards that balance the provision of State aid and the involvement of private sector creditors, in the interest of financial stability. These provisions should be used sparingly: not more than necessary, but not less either. Making the judgement in concrete cases, is not easy and requires, in my view, the full cooperation of the competition, supervision and resolution authorities.

This brings me to my third point, which concerns the modalities of cooperation. As I mentioned at the outset, new rules of engagement are, in my view, needed. There should be systematic contact and exchange between the three relevant authorities, both in normal and crisis situations. The Single Supervisory and Resolution Mechanisms have recently moved forward and established a bilateral memorandum of understanding. Communication between the two authorities is frequent and generally works well; it will be tested further in concrete circumstances. Extending these exchanges to the Commission’s competition arm seems a logical and desirable next step.

Finally, let me offer one further reflection stemming from the existence of a trade-off between competition and stability in banking, which – as I have argued – banking supervision can mitigate but not eliminate completely. Bank efficiency and stability are valuable goals, especially because banking permeates so many economic and social interactions among individuals. But the “desirable” or “acceptable” level of efficiency and stability is subjective: it depends on people’s preferences. It is difficult to detect and to measure, individually and, even more so, collectively. The question arises: who should decide what the “right” level of risk in a banking system should be? In practice, this choice today is made by banking supervisors and regulators, based on generically defined mandates.^[27] But their inherent political nature of this choice suggests that representative institutions should, in a well-functioning democracy, have a say. The banking supervisor should be given the instruments and the independence to achieve the level of risk that is collectively desired. This approach would entail major institutional reform, of a kind that has never been attempted. It would bring in several complexities, including the fact that financial stability would need to be measured more precisely. Whether we will move in that direction in the future remains to be seen. In the meantime, I think it would be desirable that the nature and implications of the trade-off between efficiency and stability in banking were debated more regularly, and in a more informed way, by political circles and public opinions.

Thank you for your attention.