The literature on financial stability often argues that increased competition causes riskier banking behavior and deteriorates bank assets, and therefore, financial liberalization is a source of Financial instability. Examples are Chantal. (1986), Riordan (1993), Gehrig (1998), Schnitzer (1999), Dell.Ariccia (2000), and Hellmann et al. (2000). Despite such a consensus, the empirical findings regarding the effects of increased competition on risk are mixed.
On the one hand, there is evidence of a link between financial crises and financial liberalization1. On the other hand, among the European emerging economies, it seems that those banking sectors with better performances are those that greatly reduced their entry restrictions. Lifting intrastate restrictions of the US banking sector also contributed to the substantial improvement in loan quality, according to Jayaratne and Strahan (1996). This
raises the issue whether the current consensus regarding the relationship of banking competition and risk taking is justified.
This issue is directly related to the on-going effort of building sound banking systems. In the past two decades, many financial markets have resorted to financial liberalization in order to foster financial deepening. In the mean-time, the frequency and degree of severe ness of financial crises have increased. The question is whether there are inherent trade-offs between efficiency, indicated by lower loan rates, and safety of the financial system, and between financial deepening and stability. If there are such trade-offs, is increased competition a source, as has been widely accepted? Policy makers have gradually realized that the role of regulation is lim-ited in building a sound banking system. Establishing an effective incentive structure is an equally important concern. One aspect is to improve banks.
incentives for acquiring information. Needless to say, this role of banks is
1See, e.g., Demirg¨u¸c-Kunt and Detragiache (1998) and Gruben et al. (1999).vcrucial in achieving Þnancial stability and in allocating Þnancial resources efficiently. Again, the question raised here is what role market structureplays in banks. incentives for acquiring information.
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