Market Power, Loan Market Diversification, and Risk-Return Trade-Offs within Banking Sectors

Abstract

This study provides rigorous empirical evidence that an increase in market power of dominant banks within deposit markets does not necessarily translate into attenuation of non-dominant banks' capacity for funding of loan commitments. This is evident in the finding that while non-dominant banks end up with smaller shares of an expanded deposit market, they simultaneously arrive at deposit bases that are larger. Given it is sizes of deposit bases that are important for each of funding of loan commitments, and funding of new loans, resources required for competition within loan markets do not suffer any impairment. Consistent with stated findings, increase in intensity of competition within banking sectors is accompanied by dampening of non-dominant banks' capacity for monopoly pricing. Empirical findings demonstrate that diversification across industries within loan markets enables dampening of risk magnifying effects of competition, implying imposition of mandatory sectoral allocations on banks is detrimental to stability of banking sectors. Study findings provide empirical validation for hitherto untested intermediation theory of commercial banking, and indicate that optimality of liquidity provision by Central Banks is sufficient for arrival at stability of well functioning banking sectors. Totality of study findings provide evidence that increase to intensity of competition within deposit markets does not necessarily induce deterioration to stability of banking sectors.

Keywords: Market Power, Diversification, Risk, Return, Bank Stability, Competition

JEL Classification: G21, L11