This paper examines the causal relationship between banking competition and financial stability. We find that an exogenous competition shock significantly improved the stability of banks, consistent with the ‘competition-stability hypothesis’. We show that banks improved their cost efficiency and reduced credit risks in response to U.S. banking deregulation. In addition, we show the competition shock had a larger impact on banks who were initially operating in a less competitive environment. Our findings provide the first quasi-natural experimental evidence on the non-linear relationship between bank competition and financial stability.
|Sheffield economic research paper series
- Bank competition
- financial stability