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Do Basel Accords influence competition in the banking industry? A comparative analysis of Germany and the UK

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Abstract

This paper compares the impact of Basel Accords on the degree of competition in the German and UK banking industries. The banking sector is heavily regulated in terms of capital requirements, and the Basel Accords regard both the optimal level of capital that banks have to hold (Pillar I), and the complementary supervisory review of the banks’ compliance to the capital requirement rules (Pillar II), and the market discipline via disclosure, where the aim is enhancing banking transparency (Pillar III). We argue that if regulation raises the cost of entry into the banking industry and that of staying in the sector, there is no need for the existing banks to dissipate their profits in order to maintain the dominant position they eventually have. On the one hand, the regulation impacts profits in the short run by imposing higher capital requirements that are tighter for smaller banks; on the other hand regulation reduces the threat by potential entrants at no extra cost for the existing banks. The likely outcome of these incentives is that profit-oriented systems invest rents in new technology, able to escape the regulation that, in turn, prevents new entrants from entering into the field.

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Notes

  1. Basel I (1988), Basel II (2004), and Basel III (2010) represent the prudential banking regulation issued by the Basel Committee on Banking Supervision, with the aim of promoting worldwide supervision and enhancing financial stability at a global level. To this purpose, capital requirements ensure that banks keep enough capital so that they are able to manage the risks they take in carrying out their activities [1].

  2. Basel Committee on Banking Supervision [2].

  3. Dow [3].

  4. Basel Committee on Banking Supervision [4].

  5. Basel Committee on Banking Supervision [5].

  6. Lastra and Wood [6].

  7. Nier and Baumann [7].

  8. Gudmundsson et al. [8].

  9. Angelini and Cetorelli [9].

  10. Fostering the optimal balance between costs and production helps the efficiency of banks. In turn, this leads to a higher quality of products, and enhances innovation and stability in the banking sector. OECD Competition Committee [10].

  11. See also Schaeck et al. [11].

  12. Claessens and Leaven [12].

  13. See also, Bikker and Bos [13].

  14. Caggiano et al. [14].

  15. Baker and Wurgler [15].

  16. While in bank-based financial systems, banks play a leading role as the suppliers of external funding to non-financial firms; in the market-based financial systems, instead, the securities market plays the leading role in firms’ financing choices [16].

  17. The Liberal Market Economies (LME) are characterized by large, well-developed equity markets, and rely more on the market forces and in competitive market arrangements. The Coordinated Market Economies (CME), rely more on non-market relationships, like strategic interaction among firms and other actors [17].

  18. Afanasenko and Reichling [18].

  19. Gola and Roselli [19].

  20. The evidence of the higher number of failures, mergers and acquisitions in the UK banking system, compared with the German system during 2007 onwards, can be seen in the light of a higher cost of adjustment to equilibrium of the former with respect to the latter, and therefore a higher cost of adjustment to Basel.

  21. Op. Cit., Mullineux and Terberger [20].

  22. According to the “theory of dissipation of rents”, the current producers, being under threat by potential entrants, have to invest their extra profits (for example in new technology) to maintain dominant positions. In other words, competition plays a key role not only among existing players, but also among existing and potential players.

  23. Banks can, for example invest to further financial innovation. They can also, at worst, behave unethically, for example acting as a cartel.

  24. The Committee is not an international supervisory authority, but rather an informal group of central banks and supervisory agencies. It was initially composed by central banks and supervisory agencies of the G10 Countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States). In 2009, it expanded its membership and now includes 27 jurisdictions (Argentina, Australia, Brazil, China, European Union, Hong Kong, India, Indonesia, Korea, Luxembourg, Mexico, Russia, Saudi Arabia, Singapore, South Africa, Spain and Turkey). Given the nature of the Committee, its decisions do not have any legal force. These decisions are instead general principles, supervisory standards, and recommendations for the best practice to which the states are expected to comply in order to achieve a greater degree of harmonization towards common regulatory standards. Op. Cit. Basel Committee on Banking Supervision [2].

  25. In fact, banks’ failures produce externalities and spillovers which represent the costs to be borne by society and which are very large, probably larger than the private costs to individual financial institutions.

  26. Basel Committee on Banking Supervision [21].

  27. Molostova [22].

  28. A more risk-sensitive calculation enables the capital requirements to reflect the real financial features of the individual institution.

  29. The VaR is an index which summarizes the total risk in a portfolio of financial assets in a single number.

  30. Op. Cit., Basel Committee on Banking Supervision [4].

  31. Op. Cit., Basel Committee on Banking Supervision [4].

  32. Thoraval [23].

  33. In broad terms, market discipline refers to a market-based incentive scheme in which investors in bank liabilities, such as subordinated debt or uninsured deposits, “punish” banks for greater risk-taking by demanding higher yields on those liabilities [7].

  34. Basel Committee on Banking Supervision [24].

  35. Basel Committee on Banking Supervision [25].

  36. See also, Gleeson [26].

  37. This explains why medium-size enterprises, which usually have limited access to the capital market, provide the largest share of German’s Gross Domestic Product (GDP) [27].

  38. At the end of 2012, market concentration, which is measured as the share of the total assets held by the five largest banks, ranged from almost 90% in Estonia to just over 30% in Germany.

  39. Op. Cit., European Central Bank [28].

  40. A large part of the market share is held by publicly owned and cooperative companies, therefore they are less open to private shareholders than other European countries, International Monetary Fund [29]. The share of the banking-system assets listed on a stock exchange was notably lower than average of the other European countries: less than 45 percent against the average which was 65 percent.

  41. The German banking system relies heavily on the net interest income as a main source of income. In other words there is a lack of diversification of the banking activities. Diversification also means risk diversification, and therefore more room for further opportunities of profit.

  42. The German central bank defines the low-interest rate environment as a growing burden on the profitability of German banks, because it makes the net interest margin fall [30].

  43. The income-cost ratio of German banks has been proved to be, on average, notably higher than in other European countries and the US, and the return on equity is remarkably lower, in comparison.

  44. Bush et al. [31].

  45. In 1971 the Bank of England moved to a more market-related monetary environment under a policy, known as Competition and Credit Control, with the aim of ending collusion on interest rates, and at eliminating barriers between different types of intermediaries, by widening the range of activities to be run by banks. In addition, the 1986 Financial Services Act started a wave of deregulation of financial markets, known as the “Big Bang”. The “Big Bang” refers to a series of reforms aimed at eliminating anticompetitive practices in order to allow London’s financial market to compete with its international competitors, especially the US. All protective measures were removed and the fixed commission charges abolished [32].

  46. Nowadays, non-interest income accounts for more than 60% of banks’ earnings into UK, whilst it was just a small percentage during the 1980s.

  47. The main feature of public goods and services is that they are not supplied with the aim of making a profit, but rather benefit the general public. This is why they are supplied at a relatively low cost.

  48. The notion of risk refers to “uncertainty”, therefore it encompasses both losses (downside risk) and profits (upside risk). What constitutes the risk premium is the profit which is made for taking more risk for bearing more uncertainty. In other words, the greater the risk, the greater the profit.

  49. See Silverman [33].

  50. It is not a surprise that the large banks retain lower amount of regulatory capital than the others, since, as noted, only large and more sophisticated banks are suitable to adopt the IRB models [34].

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Authors and Affiliations

  1. King’s Business School, King’s College London, 30 Aldwich, London, WC2B 4BG, UK

    Leone Leonida & Eleonora Muzzupappa

  2. SEAM, University of Messina, Piazza Pugliatti 1, Messina, 98100, Italy

    Leone Leonida

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Leonida, L., Muzzupappa, E. Do Basel Accords influence competition in the banking industry? A comparative analysis of Germany and the UK. J Bank Regul 19, 64–72 (2018). https://doi.org/10.1057/s41261-017-0053-0

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