2/9/16: Does bank competition reduce cost of credit?

In the wake of the Global Financial Crisis, there has been quite a debate about the virtues and the peril of competitive pressures in the banking sector. In a paper, published few years back in the Comparative Economic Studies (Vol. 56, Issue 2, pp. 295-312, 2014 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2329815), myself, Charles Larkin and Brian Lucey have touched upon some of the aspects of this debate.

There are, broadly-speaking two schools of thought on this subject:

1. The market power hypothesis - implying a negative relationship between bank competition and the cost of credit (as greater competition reduces the market power of banks and induces more competitive pricing of loans). This argument is advanced by those who believe that harmful levels of competition can lead to banks mispricing risk while competing with each other. 
2. The information hypothesis postulates a positive link between credit cost and competition, as the banks may be facing an incentive to invest in soft information. 

Now, a recent paper from the Bank of Finland, titled “Does bank competition reduce cost of credit? Cross-country evidence from Europe” (authored by Zuzana Fungáčová, Anastasiya Shamshur and Laurent Weill, BOFIT Discussion Papers 6/2016, 30.3.2016) looks at the subject in depth.

Per authors, “despite the extensive debate on the effects of bank competition, only a handful of single-country studies deal with the impact of bank competition on the cost of credit. We contribute to the literature by investigating the impact of bank competition on the cost of credit in a cross-country setting.” The authors take a panel of companies across 20 European countries “covering the period 2001–2011” and study “a broad set of measures of bank competition, including two structural measures (Herfindahl-Hirschman index and CR5), and two non-structural indicators (Lerner index and H-statistic).”

The findings are interesting:

• “bank competition increases the cost of credit and …the positive influence of bank competition is stronger for smaller companies”
• These results confirm “the information hypothesis, whereby a lack of competition incentivizes banks to invest in soft information and conversely increased competition raises the cost of credit.” 
• “The positive impact of bank competition is influenced by two additional characteristics. It is lower during periods of crisis, and the institutional and economic framework influences the relation between competition and the cost of credit.”
• Overall, however, the “positive impact of bank competition is …influenced by the institutional and economic framework, as well as by the crisis.”

The authors ‘take-away lesson” for policymakers is that “pro-competitive policies in the banking industry can have detrimental effects, … [and] banking competition can have a detrimental influence on financial stability and bank efficiency.”

I disagree. Judging by the above, higher costs of credit overall, and higher costs of credit for smaller firms, may be exactly what is needed to induce greater efficiency and reduce harmful distortions from over-lending. As long as these higher costs reflect actual risk levels.