Breaking up banks could increase instability, research finds

Banking systems with small numbers of large banks are more stable and less likely to undergo crises, according to World Bank and NBER economists.

The assumption that large banks are a cause of systemic risk might not be justified, according to research due to be published soon by three economists from the World Bank and the US National Bureau of Economic Research (NBER).

Thorsten Beck and Asli Demirgüç-Kunt of the World Bank and Ross Levine of the NBER looked at banks from 47 countries over the 1980–1997 period. They found that more concentrated banking systems – those made up of a small number of large banks – were less likely to undergo financial crises. For example, the US, with a large number of banks, has seen more crises than the UK, which has proportionately fewer and larger banks, they wrote.

Furthermore, other regulatory measures aimed at improving bank stability – such as restricting bank activities – could also be counterproductive. "Banking systems where a larger fraction of entry applications are denied, and those where regulations restrict banks from engaging in non-loan-making activities have a greater likelihood of experiencing a systemic crisis," the economists say.

Regulators have proposed measures along these lines – January saw the US announcement of the proposed 'Volcker rule', which would cap banks' market share in terms of assets and would also restrict their involvement in non-core activities such as prop trading, hedge funds and private equity.

But such measures could undermine the banks they seek to protect, the World Bank/NBER researchers argue. "Concentrated banking systems might enhance market power and boost bank profits. High profits provide a 'buffer' against adverse shocks and increase the charter or franchise value of the bank, reducing incentives for bank owners and managers to take excessive risk and thus reducing the probability of systemic banking distress." Also, smaller numbers of banks are easier to regulate, they add.

They warn, however, that there is still no way of knowing why the link between concentration and stability exists – and add that several researchers have found the reverse. "Our findings should therefore not be seen as a recommendation for policymakers to foster bank concentration," they conclude.