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Competition, liquidity and stability: international evidence at the bank and systemic levels
In order to distinguish essays and pre-prints from academic theses, we have a separate category. These are often much longer text based documents than a paper.
posted on 21.02.2017by Nguyen, Thi Ngoc My
This thesis investigates the impact of market power on bank liquidity; the association between competition and systemic liquidity; and whether the associations between liquidity and stability at both bank- and systemic- levels are affected by competition. The first research question is explored in the context of 101 countries over 1996-2013 while the second and the third, which require listed banks, use a smaller sample of 32 nations during 2001-2013. The Panel Least Squares and the system Generalized Method of Moments estimators are employed to assess these associations. These research issues are further examined separately for countries with different level of economic development. Such divisions are essential since these countries exhibit varying degrees of market power, banking competition, liquidity risk preference, regulations and financial infrastructures.
Regarding the market power-liquidity relationship, the findings suggest an inverted U-shaped association between market power and bank liquidity. With an initial increase in market power, banks increase their liquid assets and become net lenders in the interbank markets. When market power exceeds a certain threshold, however, banks hold less liquid assets and become net interbank borrowers. For a given level of market power, ceteris paribus, banks in more developed nations have lower investments in asset liquidity and obtain more funding through the interbank market than those in their developing country counterparts.
While competition benefits bank-level asset and funding liquidity, it decreases systemic liquidity. By affecting loan profitability and banks’ incentives to hold liquid reserves, competition influences interbank market liquidity and thus asset prices. This in turn influences banks’ ability to withstand liquidity shocks and systemic liquidity crises.
On the impact of competition on the association between liquidity and stability, bank market power seems to reinforce the positive impact of funding liquidity on bank stability. In contrast, banking systemic liquidity appears only to enhance systemic stability in less competitive markets. This is because greater competition encourages banks to assume more risks (i.e. credit and capital risks) that offset systemic liquidity’s positive impact.
This thesis offers several contributions to the bank liquidity hoarding and industrial organization literatures by showing that bank liquidity risk varies with market power. It similarly expands the financial intermediation literature by providing evidence that strategic interactions among banks expose them to systemic liquidity crises. It further adds to the competition-stability literature by providing evidence that competition leads to a reversal of the benefits of liquidity on stability at both bank- and systemic- levels. It also improves the prior methodology by deriving a systemic liquidity risk indicator using a Principal Component Analysis, examining both bank- and systemic-levels of liquidity and stability, employing a three year rolling window to reflect more frequent changes of competition over time and using bank distance-to-capital proposed by Chan-Lau and Sy (2007) in addition to the traditional distance-to-default in calculating banking systemic stability.
These findings should have implications for policymakers, regulators, central bankers and investors in wide-range of countries. Policy makers should benefit from learning that the new international bank liquidity standards (fully implemented by 2019) incorporate an adjustment to reflect bank market power and competition. Regulators should also avoid “one size fits all” approach as bank liquidity is influenced by cross-country differences in regulation, industry characteristics, financial development and presence/absence of explicit deposit guarantees. Central bankers should learn the impact of competition on liquidity and stability when extending their liquidity support. Finally, investors should be aware their banks’ competitive environment and liquidity position before investing.