Accepted Manuscript

How Does Competition Affect Bank Systemic Risk?

Deniz Anginer, Asli Demirguc-Kunt, Min Zhu

PII: S1042-9573(13)00060-0
DOI: http://dx.doi.org/10.1016/j.jfi.2013.11.001
Reference: YJFIN 654

To appear in: Journal of Financial Intermediation

Received Date: 13 March 2012

Please cite this article as: Anginer, D., Demirguc-Kunt, A., Zhu, M., How Does Competition Affect Bank Systemic
Risk?, Journal of Financial Intermediation (2013), doi: http://dx.doi.org/10.1016/j.jfi.2013.11.001

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 How Does Competition Affect Bank Systemic Risk?

Deniz Anginer, Asli Demirguc-Kunt, Min Zhu1

October, 2013

Abstract

Using bank level measures of competition and co-dependence, we show a robust negative
relationship between bank competition and systemic risk. Whereas much of the extant
literature has focused on the relationship between competition and the absolute level of
risk of individual banks, in this paper we examine the correlation in the risk taking
behavior of banks. We find that greater competition encourages banks to take on more
diversified risks, making the banking system less fragile to shocks. Examining the
impact of the institutional and regulatory environment on bank systemic risk shows that
banking systems are more fragile in countries with weak supervision and private
monitoring, greater government ownership of banks, and with public policies that restrict
competition. We also find that the negative effect of lack of competition can be mitigated
by a strong institutional environment that allows for efficient public and private
monitoring of financial institutions.

JEL Classifications: G21, L11, L14

Keywords: Systemic risk, bank competition, credit risk, merton model, distance to default, default risk,
lerner index, bank concentration

1
Anginer, Virginia Tech, danginer@vt.edu; Demirguc-Kunt, World Bank, ademirguckunt@worldbank.org; Zhu,
World Bank, mzhu1@worldbank.org. We thank the editor (Viral Acharya), two anonymous referees, and
participants of the 2012 World Bank Economists’ Forum and 2012 Northern Financial Association Conference for
useful suggestions. This paper’s findings, interpretations and conclusions are entirely those of the authors and do not
necessarily represent the views of the World Bank, their Executive Directors, or the countries they represent.

1
1. Introduction
The impact of bank competition on financial fragility has always been a subject of active
academic and policy debate. However public policy interest in this topic has intensified after the
global financial crisis, with both academics and policymakers questioning to what extent the
“dark side” of competition and the resulting financial innovations in search of higher margins
were responsible for the crisis. While greater competition in the banking sector has led to greater
innovation and efficiency2, there is still no academic consensus on whether this competition has
also led to greater fragility, with conflicted theoretical predictions and mixed empirical results.
In parallel, the financial crisis has also led to a re-examination of risk assessment
practices and regulation of the financial system, with a renewed interest in systemic fragility and
macro-prudential regulation. This requires a focus not on the risk of individual financial
institutions, but on an individual bank’s contribution to the risk of the financial system as a
whole. Hence, there is a growing consensus that from a regulatory perspective of ensuring
systemic stability, the correlation in the risk taking behavior of banks is much more relevant than
the absolute level of risk taking in any individual institution.
In this paper we address both sets of issues by re-examining the empirical relationship
between competition and systemic risk. Unlike the extant literature which has focused on stand-
alone bank risk, our focus in this paper is on systemic risk. Hence in addition to looking at the
absolute level of risk in individual banks, we examine the correlation in the risk taking behavior
of banks, measured as the total variation of changes in default risk of a given bank explained by
changes in default risk of all other banks in a given country.
We follow Anginer and Demirguc-Kunt (2011) and use Merton’s (1974) contingent
claim pricing framework to measure bank default risk and its contribution to systemic risk.
Using a sample of 1,872 publicly traded banks in 63 countries over the period 1997 to 2009, we
investigate the impact of bank competition, as measured by the Lerner index of bank market
power on systemic risk. Our results suggest a negative relationship between competition and
systemic risk, consistent with the view that greater competition encourages banks to take on

2
Schaeck and Cihak (2010) find a positive effect of competition on profit and cost efficiency. Lin, Ma, and Song
(2010) and Demirguc-Kunt, Laeven and Levine (2004) find that tighter regulations on bank entry and bank activities
lead to higher costs of financial intermediation and lower efficiency. Turk-Ariss (2010) finds a negative association
between bank market power and cost efficiency.

2
more diversified risks, making the banking system less fragile to shocks. We also examine the
impact of the larger institutional and regulatory environment on this relationship. Correlated risk
taking behavior is higher in countries with weak supervision and private monitoring, high
government ownership of banks, and in countries with public policies that restrict competition.
The competition – systemic fragility relationship is also sensitive to the underlying institutional
environment. We find that the negative effect of lack of competition can be mitigated by a
strong institutional environment that allows for efficient public and private monitoring of
financial institutions.
Our paper contributes to a large literature on the relationship between competition and
stability in the financial system. 3 Economic theory is conflicted on the impact of banking
structure on financial stability. On the one hand, the charter value view of competition suggests
there could be significant stability costs of competition, since too much competition may lead to
excessive risk taking as it reduces margins (Marcus 1984; Keeley 1990; Allen and Gale 2004).
Proponents of this view argue that in an environment with greater competition, the pressure on
profits will make banks choose riskier portfolios, leading to greater fragility (Hellman, Murdoch
and Stiglitz 2000). Others argue that in a more competitive environment, banks earn lower rents,
which also reduces their incentives for monitoring (Boot and Thakor 1993; Allen and Gale
2000).4 Large banks can also diversify better so that banking systems dominated with a few
large banks are likely to be less fragile than banking systems with many small banks (Allen and
Gale 2004). Finally, some hold that a few large banks are easier to monitor and supervise
compared to competitive banking systems with a large number of small banks. These arguments
are all consistent with competition leading to greater fragility.
On the other hand, lack of competition may also exacerbate bank fragility. Banks with
greater market power tend to charge higher interest rates to firms, inducing them to take on
greater risk, and hence increasing the fragility of the financial system as well (Boyd and De
Nicolo 2005). 5 Importantly, large banks frequently receive “too-big-to-fail” subsidies from

3
See for example literature reviews by Carletti (2008) and Degryse and Ongena (2008).
4
Dell’Ariccia and Marquez (2004) show that more intense competition may induce banks to switch to more risky,
opaque borrowers, and Hauswald and Marquez (2006) show competition makes banks acquire less information on
borrowers.
5
In extensions of Boyd and de Nicolo model that allow for imperfect correlation in loan defaults, Martinez-Miera
and Repullo (2010) and Hakenes and Schnabel (2011) show that the relationship between competition and risk is U
shaped. Wagner (2010) allows for risk choices to be made by borrowers as well, which overturns the Boyd and De

3
safety net policies, distorting their risk taking incentives and destabilizing the financial system as
a whole (Kane 1989; Acharya, Anginer and Warburton 2012). Finally, as the global financial
crisis has amply illustrated, large banks also can be more difficult to supervise given their
complexity, and their ability to politically capture their supervisors (Johnson and Kwak 2010).
Most of the theoretical literature on bank competition and stability focuses on individual
bank risk, not on correlated risk taking by banks. However, modeling correlated risk taking has
been the focus of theoretical papers after the recent crisis (see for example Brunnermeier 2009;
Daneielsson, Shin and Zigrand 2009; Battiston, Gatti, Gallegati, Greenwald, and Stiglitz 2009;
among others).With respect to empirical studies on bank systemic risk, Brunnermeier, Dong, and
Palia (2011) show that bank non-interest income is positively correlated with systemic risk and
Van Bekkum (2010) finds that incentive compensation is associated with greater bank systemic
risk. These papers only consider US banks and do not address issues of bank competition.
Given the current policy relevance of the topic and conflicting theoretical predictions,
there is also a growing empirical literature on the impact of bank competition on bank fragility.
Individual country studies - mostly for the US - have not come up with conclusive findings.6
Cross-country analyses have shown that more concentrated banking systems are less likely to
suffer a systemic banking crisis but so are more competitive banking systems, potentially
suggesting a stabilizing effect for having a contestable banking system (Beck, Demirguc-Kunt,
and Levine 2006; Schaeck, Cihak, and Wolfe 2009). Others have shown that banks in more
competitive banking systems hold more capital, which could explain the positive effect of bank
competition on stability (Berger, Klapper, and Turk-Ariss, 2009; Schaeck and Cihak 2010). At
the bank level, Beck, De Jonghe, and Schepens (2011) find a positive correlation between
accounting measures of bank soundness and market power, and examine the cross-country
heterogeneity in this relationship, identifying links with regulatory and institutional features.
Our contribution to this literature isfour-fold. First, unlike most of the previous papers
using bank level data to investigate the link between competition and bank fragility, we do not
focus solely on individual bank risk, but also the co-dependence of those risks, hence addressing
macro-prudential regulation issues of current policy interest. Second, we compute default risk
from the structural credit risk model of Merton (1974) instead of the commonly used accounting

Nicolo results. Allen and Gale (2004) also show that competition –stability relationship can be complex, where
competition can also increase stability.
6
See for example, Boyd and Runkle (1993) for an analysis of US bank holding companies.

4
based measures of risk such as z-scores of bank soundness. Using z-scores in investigating the
relationship between bank risk and competition is particularly problematic since z-scores and
Lerner index of market power are both calculated using profitability measures, making their
positive correlation potentially spurious. In contrast, we use risk measures developed in Anginer
and Demirguc-Kunt (2011), applying the recent advances made in the risk pricing literature7 to
an international sample of publicly traded banks in 63 countries. Third, we are able to examine
the relationship between competition and systemic risk at the bank level, while controlling for a
variety of bank characteristics that may affect systemic risk. Finally, the cross-country nature of
our dataset allows us to examine the impact of the institutional and regulatory environment on
systemic stability as well as the relationship between competition and correlated risk taking
behavior of banks, which are of particular interest for policy.
The rest of the paper is organized as follows. Section 2 describes the construction of the
sample and variables. Section 3 presents the empirical results and discusses the implications.
Section 4 concludes.

2. Data and Empirical Methodology

2.1. Sample
In this section we describe the data sources used in this paper. We obtain bank level financial
information from Bankscope. We use stock market information from Compustat Global for
international banks and stock market information from CRSP for U.S. banks. The Bankscope
database reports detailed balance sheet and income statement information for both public and
private banks and covers over 90% of the total banking assets in any given country. The
Compustat Global database provides daily stock price information for both active and delisted
companies, accounting for 98% of the global stock market capitalization. CRSP is the standard
source for stock price information of U.S. companies. Our final sample consists of 1,872 unique
publicly traded banks in 63 countries from 1997 to 2009. Sample size varies across regression
specifications because not all variables are available for all bank year observations.

2.2. Systemic Default Risk Measures

7
See Chan-Lau and Gravelle (2005), Elsinger, Lehar and Summer (2005), Avesani, Pascual, and Li (2006), Adrian
and Brunnermeier (2009), and Huang, Zhou, and Zhu (2009).

5
We use the Merton (1974) contingent claim framework to measure bank default risk. This
approach treats the equity value of a company as a call option on the company’s assets. The
probability of default is computed using the “distance-to-default” measure, which is the
difference between the asset value of the firm and the face value of its debt, scaled by the
standard deviation of the firm’s asset value. The Merton (1974) distance-to-default measure has
been shown to be good predictor of defaults outperforming accounting-based models (Hillegeist,
Keating, Cram, and Lundstedt 2004; Campbell, Hilscher and Szilagyi 2008; Bharath and
Shumway 2008). Although the Merton distance-to-default measure is more commonly used in
bankruptcy prediction in the corporate sector, Merton (1977a, 1977b) points out the applicability
of the contingent claims approach to pricing deposit insurance in the banking context. Bongini,
Laeven and Majnoni (2002), Bartram, Brown and Hund (2007), Hovakimian, Kane, and Laeven
(2012), among others, have used the Merton model to measure default risk of commercial banks.
In addition, compared to traditional bank risk measures such as z-score, the market based
distance to default measure has several distinct advantages. First, the distance to default measure
can be updated more frequently. While the balance sheet information for international banks is
only available at annual frequency, stock market information is available on a daily basis.
Second, stock market information is usually forward looking and thus the distance to default
measure reflects market perceptions of a bank’s expected soundness in the future.
We follow Campbell, Hilscher and Szilagyi (2008) and Hillegeist, Keating, Cram, and
Lundstedt (2004) to calculate Merton’s distance-to-default measure. Specifically, the market
equity value of a company is modeled as a call option on the company’s assets:

 
  
   
  1    



log         2 ! (1)
  ;      √!
 √!

In equation (1), VE is the market value of a bank. VA is the value of the bank’s assets. X is the
face value of debt maturing at time T. r is the risk-free rate and d is the dividend rate expressed
in terms of VA. sA is the volatility of the value of assets, which is related to equity volatility
through the following equation:

6

  
 
  (2)



We simultaneously solve the above two equations to find the values of VA and sA. We use
the market value of equity for VE and total liabilities to proxy for the face value of debt X. Since
the accounting information is on an annual basis, we linearly interpolate the values for all dates
over the period, using beginning and end of year values for accounting items. The interpolation
method has the advantage of producing a smooth implied asset value process and avoids jumps
in the implied default probabilities at year end. sE is the standard deviation of daily equity
returns over the past year. In calculating standard deviation, we require the bank to have at least
90 non-missing daily returns over the previous twelve months. T equals one year. r is the one
year US treasury yield, which we take to be the risk free rate. We use the Newton method to
simultaneously solve the two equations above. For starting values for the unknown variables, we
use VA = VE + X and sA = sEVE/(VE+X). We winsorize sE and VE/(VE+X) at the 5th and 95th
percentile levels to reduce the influence of outliers. After we determine asset values VA, we
follow Campbell, Hilscher and Szilagyi (2008) and assign asset return m to be equal to the equity
premium (6%). Merton’s distance-to-default (dd) is finally computed as:


$%&     '     !
 2
 
(3)
 √!

The default probability is the normal transform of the distance-to-default measure and is defined
as PD = F (–dd), where F is the cumulative distribution function of a standard normal
distribution.
As mentioned earlier, our focus in this paper is on systemic stability. Hence we examine
the correlation in the risk taking behavior of banks, measured as the total variation of changes in
default risk of a given bank explained by changes in default risk of all other banks in a given
country. We use as our measure of systemic stability the R-squared obtained from regressing
changes in bank default risk on changes in average default risk of all other banks in a given
country. To calculate this measure, for each bank i in country j in week w of year t, we first
compute a weekly Merton’s distance-to-default (ddi,j,t,w). Then for each bank i in year t, we run a

7
time series regression of bank i’s weekly change in distance-to-default on country average
weekly change in distance-to-default excluding bank i itself:

3
1
∆),+,,,-  .),+,,  /),+,, 1 ∆2,+,,,-  6),+,,,- (4)
0
24,25)

We follow Morck, Yeung, and Yu (2000) and Karolyi, Lee, and Van Dijk (2011) and use
the logistic transformation of R-squared from the above regression, which is equal to log(rsqi,j,t /
(1-rsqi,j,t)), to measure systemic risk posed by bank i. R-squared is only computed for banks with
at least twenty-six weeks of changes in weekly distance-to-default data in a year. Higher R-
squared for a given bank suggests that the bank is exposed to similar sources of credit risk as
other banks in a given country. Higher R-squared also suggests that there are channels of inter-
dependency between the bank and others in a given country. Both interconnectedness and
common exposure to risk makes the banking sector more vulnerable to economic, liquidity and
information shocks. We measure the systemic risk with respect to country average as bank
regulation and supervision take place at the country level, thus from a policy perspective,
systemic risk at the country level is more relevant. In addition, Acharya (2005) suggests that
banks will have incentives to take on correlated risks if there is an implicit guarantee provided by
the state to cover losses stemming from a systemic crisis. Bertay, Demirguc-Kunt, and Huizinga
(2012) also suggest that financial safety nets reduce bank internationalization because
international banks are unlikely to be bailed out by local governments of the overseas countries
where they operate.
As a robustness check, we also compute one additional measure of systemic risk.
Following Adrian and Brunnermeier (2010), we compute a conditional value at risk measure
(CoVar) for each of the banks in our sample using quantile regressions. Quantile regressions
estimate the functional relationship among variables at different quantiles (Koenker and Hallock
(2001)) and allow for a more accurate estimation of the credit risk co-dependence during stress
periods by taking into account nonlinear relationships when there is a large negative shock. As in
Adrian and Brunnermeier (2010), we estimate a time series CoVar measure using a number of
state variables. We run the following quantile regressions over the sample period:

8
 ∆),, 7)  8) 9,  6),,
∆:;<', 7=>=,?@|)  /=>=,?@|) ∆),,  8=>=,?@|) 9,  6=>=,?@|),, (5)

In equation (5), ∆),, is the change in Merton distance-to-default for bank i in week
t. ∆SystemddI is the change in the value-weighted Merton distance-to-default for all banks in a
given country. 9, are lagged state variables and include change in the term spread (TERM),
change in the default spread (DEF), CBOE implied volatility index (VIX), S&P 500 return
(SPRET) and the change in the three month t-bill rate (RATE). The ∆CoVar variable is then
computed as the change in the VaR of the system when the institution is at the qth percentile (or
when the institution is in distress) minus the VaR of the system when the institution is at the 50%
percentile:

M M P
PM  ∆
∆J%KL:;<',  /N=>=,?@|) ∆ QR%
O,, O,,  (6)

We compute the ∆CoVar measure at q=1% for each bank in our sample for three time
periods: prior to 2002, 2002 to 2007, and after 2007, in order to accommodate the time varying
business conditions during the three time periods (Moore and Zhou 2011).8 ∆CoVar measures
the risk contribution of an individual bank, with lower values indicating greater contribution.
In terms of measuring risk co-dependence, using R-squared has advantages over
alternative measures as described in Pukthuanthong and Roll (2009) and Bekaert and Wang
(2009). For instance, ∆CoVar as a measure of systemic risk may suffer from volatility bias as it
may underestimate systemic risk in good times. Billio, Pelizzon, Lo and Getmansky (2012) point
out that during periods of substantial financial innovation, the risk codependence of financial
institutions may be high but substantial losses of the banking system may have yet not occurred.
This results in low levels of ∆CoVar that do not accurately capture the high risk codependence
among financial institutions. We use the R-squared as our primary measure of systemic risk to
better capture variation in the correlations of bank risk taking over time and use ∆CoVar as a
robustness check. Our results are robust across different measures of systemic risk.

8
The pre 2002 time period covers the internet bubble and the 9-11 terrorist attack. The post 2007 time period covers
the recent global financial crisis. We obtain similar results if we estimate ∆CoVar over the entire sample period or
compute the ∆CoVar measure at the 5th quantile.

9
2.3. Competition Measures
In this paper, we use the Lerner index as our main measure of lack of competition. The Lerner
index is a proxy for profits that accrue to a bank as a result of its pricing power in the market. It
is measured at the bank level and has been utilized in a number of banking studies.9
We follow the methodology used in Demirguc-Kunt and Martinez-Peria (2010) and first
estimate the following log cost function for each country:

log(Cit) = α + β1×log(Qit) + β2×(log(Qit))2 + β3×log(W1,it) + β4×log(W2,it) + β5×log(W3,it)

+β6×log(Qit)×log(W1,it) + β7×log(Qit)×log(W2,it) + β8×log(Qit)×log(W3,it)
+ β9×(log(W1,it))2 + β10×(log(W2,it))2 + β11×(log(W3,it))2 + β12×log(W1,it) ×log(W2,it) (7)
+ β13×log(W1,it) ×log(W3,it) + β14×log(W2,it) ×log(W3,it) + Θ×Year Dummies
+ Ω×Bank Specialization Dummies + εit

In equation (7) above, Cit is total costs and is equal to the sum of interest expenses,
commission and fee expenses, trading expenses, personnel expenses, other admin expenses, and
other operating expenses, measured in millions of US dollars. Qit is the quantity of output and is
measured as total assets in millions of US dollars. W1,it is the ratio of interest expenses to total
assets. W2,it is personnel expenses divided by total assets. W3,it is the ratio of administrative and
other operating expenses to total assets. The subscripts i and t denote each bank and year
respectively. We take natural logarithm of all variables and estimate the regression for each
country in our dataset using pooled ordinary least squares (OLS). We include calendar year and
bank specialization dummies in the regression. All variables are winsorized at the 1st and 99th
percentile levels to reduce the influence of outliers. We further impose the following five
restrictions on regression coefficients to ensure homogeneity of degree one in input prices:

β3+β4+β5 = 1; β6+β7+β8 = 0; β9+β12+β13 = 0; β10+β12+β14 = 0; β11+β13+β14 = 0 (8)

We then use the coefficient estimates from the previous regression to estimate marginal
cost for bank i in calendar year t:

9
See for instance, Demirguc-Kunt and Martinez-Peria (2010) and Beck, De Jonghe, and Schepens (2011).

10
 MCit = ∂Cit/∂Qit = Cit/Qit × [β1 + 2×β2×log(Qit) + β6×log(W1,it)
(9)
+ β7×log(W2,it) + β8×log(W3,it)]

The Lerner index is then computed as:

Lernerit = (Pit - MCit) / Pit (10)

Above, Pit is the price of assets and is equal to the ratio of total revenue (sum of interest
income, commission and fee income, trading income, and other operating income) to total assets.
We also employ an additional measure of competition, H-statistic, based on the Panzar-
Rosse (1987) methodology. We follow Claessens and Laeven (2004) and in each calendar year
estimate the following reduced-form revenue regression for each country:

log(Pi) = α + β1×log(W1,i) + β2×log(W2,i) + β3×log(W3,i) + γ1×log(Y1,i) + γ2×log(Y2,i)

(11)
+ γ3×log(Y3,i) + Ω×Bank Specialization Dummies + εi

Pi is total interest income divided by total assets and measures the output price of loans.
W1,i is the ratio of interest expenses to total assets. W1,i measures the input price of loans. W2,i
proxies for the input price of labor and is measured as personnel expenses divided by total assets.
W3,i is the ratio of administrative and other operating expenses to total assets and measures the
input price of capital. Control variable Y1,i is the ratio of equity to total assets, control variable
Y2,i is the ratio of net loans to total assets, and control variable Y3,i is total assets in millions of
USD. The subscript i denotes bank i. We take natural log of all variables and estimate the
regression using ordinary least squares (OLS). We winsorize all variables at the 1st and 99th
percentile levels to reduce the influence of outliers. The H-statistic, which measures the sum of
the elasticity of revenue with respect to the three input prices, is then calculated as β1+β2+β3. H
statistic ranges from -∞ to 1. An H-statistic that is equal to or smaller than zero indicates
monopoly or perfect collusion, a value between zero and one suggests oligopolistic or
monopolistic types of competition, and a value of one represents perfect competition. Therefore,
a higher H-statistic indicates a more competitive market. We take the negative value of H-
statistic so that higher value represents greater market power.

11
 We also check whether the long-run equilibrium condition of the Panzar-Rosse model is
satisfied by testing the following regression specification:

log(1+ROAi) = α + β1×log(W1,i) + β2×log(W2,i) + β3×log(W3,i) + γ1×log(Y1,i) + γ2×log(Y2,i)

(12)
+ γ3×log(Y3,i) + εi

ROAi is bank’s return on assets, which is the ratio of bank pre-tax profits to total assets. If
the banking system is in long run equilibrium, then input prices should not affect return on
assets, which indicates that β1+β2+β3 is equal to zero in equilibrium.
A number of papers have used bank concentration to proxy for banking sector
competition.10 We also examine the relationship between bank concentration and systemic risk
using the Hirschmann-Herfindahl index of bank assets and the fraction of total assets held by the
three largest commercial banks in the country.11 The recent literature, however, emphasizes the
differences between competition and concentration. Claessens and Laeven (2004) show that the
degree of concentration may be a poor proxy for the contestability of the banking sector.
Schaeck and Cihak (2010) and Love and Martinez Peria (2012) point out that competition
measures market conduct while concentration measures market structure. Bikker and Spierdijk
(2008) suggest that the concentration measures may exaggerate the level of competition in small
countries and are unreliable when the number of banks is small. Panel B of Table 2 shows that
country level bank concentration, as measured by the three bank asset concentration ratio, is
correlated with the country level average Lerner index with a Pearson correlation coefficient of
0.124 (p-value=0.001). The country average Lerner index is also correlated with the
Hirschmann-Herfindahl index of bank assets concentration with a Pearson correlation coefficient
of 0.158 (p-value=0.000). However, the univariate correlation between the country average
Lerner index and the H-statistic is not statistically significant.
The Lerner index has several advantages over alternative potential measures of market
competition. First, Beck, De Jonghe, and Schepens (2011) point out that the Lerner index
measures a bank’s pricing power and better captures the theoretical concept of bank franchise

10
See, for instance, Demirguc-Kunt, and Levine (2006). The Hirschmann-Herfindahl index of concentration is the
sum of the squares of the market shares (assets) of each bank in each country.
11
We use the three bank asset concentration ratio from the Financial Structure Dataset (Beck, Demirguc-Kunt and
Levine 2010).

12
value. Second, these authors suggest that the Lerner index, which calculates the differences
between profits of bank assets and costs of bank operations, utilizes both bank asset and funding
information and thus captures the impact of pricing power on both the asset and funding side of
the bank. Third, unlike the H-statistic, the computation of Lerner index does not require a
banking system to be in long run equilibrium (Schaeck and Cihak 2010). Fourth, Aghion, Bloom,
Blundell, Griffith, and Howitt (2005) suggest that one advantage of the Lerner index over market
concentration and market share measures of competition is that it does not rely on precise
definitions of geographic product markets. Defining geographic markets is particularly difficult
for the banking industry as many banks often operate in a number of countries. Finally, the
Lerner index is the only competition measure that is available at the bank level besides market
share. As our main purpose is to examine the bank level relationship between competition and
systemic risk, we follow Beck, De Jonghe, and Schepens (2011) and use the Lerner index as our
primary measure of competition. We use the H-statistic, bank concentration, and the
Hirschmann-Herfindahl index of bank concentration as alternative measures of competition and
structure in robustness checks.

2.4. Institutional and Regulatory Variables

As mentioned in the introduction we are interested in the impact of the larger regulatory and
institutional framework on the competition and systemic stability relationship. The main
regulatory and institutional variables used in this study come from the three surveys conducted
by Barth, Caprio, and Levine (2008). The surveys were conducted in the years 1999, 2002, and
2005. Since country level regulations change slowly over time, we use the previously available
survey data until a new survey becomes available. Specifically, we use the survey data of 1999
for years 1996 to 2001, the survey data of 2002 for years 2002 to 2004, and the survey data of
2005 for years 2005 to 2009.
We consider three groups of bank regulation/institutional variables. The first group of
regulatory variables is related to state policies that enable or restrict competition. Entry barrier
index, measures bank entry requirements and is constructed based on eight questions in the
Barth, Caprio, and Levine surveys regarding legal submissions required to obtain a banking
license in a given country. Application denied is the percentage of applications to set up a bank
that were denied in the past five years. Government ownership measures the fraction of banks

13
that are 50% or more owned by the government. The second group of variables measure bank
regulation and supervision. Activity restrictions index measures the degree to which the national
regulatory authorities allow banks to engage in securities, insurance, and real estate businesses.
Capital stringency index measures the amount of capital a bank must maintain. Supervisory
power index indicates whether the supervisory authorities have the power and the authority to
take specific preventive and corrective actions. Diversification index captures whether there are
explicit, verifiable, quantifiable guidelines for bank asset diversification and whether banks are
allowed to make loans outside of national borders.
Finally, we use data on the investor protection index and depth of credit information
sharing from Djankov, McLiesh, and Shleifer (2007) and the World Bank Doing Business
Survey.12 We also consider deposit insurance coverage. Deposit insurance coverage ratio is the
amount of deposit insurance coverage divided by deposits per capita. It is set to 1 if a country
offers full coverage. We obtain this variable from Demirguc-Kunt, Kane, and Laeven (2008).
Since the data ends in year 2003 and most countries did not change their deposit insurance
coverage till the recent financial crises, we use the deposit insurance coverage in 2003 for years
2003 to 2007. 13 These variables measure the strength of private monitoring and information
sharing in each country. A detailed list of variables and definitions are provided in Appendix I.

2.5. Control Variables

In examining the relationship between competition and systemic stability we control for a
number of bank and country level variables. We follow previous studies (e.g., Beck, De Jonghe,
and Schepens (2011)) in the literature to control for bank size, funding structure, business model,
and profitability in our study. Bank level controls come from Bankscope. For each bank, each
year, we calculate bank size (natural logarithm of total assets), reliance on non-deposit short term
funding (non-deposit short term funding divided by the sum of deposits and non-deposit short
term funding), profitability (net income divided by total assets), market-to-book ratio (market
value of assets divided by book value of assets), non-interest income share (non-interest income
divided by total operating income), and provisions (loan loss provisions divided by total assets).

12
Details on how these variables are constructed are available on World Bank’s Doing Business Survey website at
http://www.doingbusiness.org/methodology.
13
See Demirguc-Kunt, Kane, and Laeven (2008) for a detailed analysis of various features of deposit insurance
mechanisms.

14
We winsorize all financial variables at the 1st and 99th percentile level of their distributions to
reduce the influence of outliers and potential data errors.
Country level controls are collected from a number of sources. We obtain economic
development measures from the World Bank’s World Development Indictor (WDI) database.
We use the natural logarithm of GDP per capita to measure the economic development of a
country, the variance of GDP growth rate to measure economic stability, and imports plus
exports of goods and service divided GDP to measure global integration (Karolyi, Lee, and Van
Dijk 2011). In addition, we obtain private credit divided by GDP from the Financial Structure
Dataset (Beck, Demirguc-Kunt, and Levine 2010) to control for banking sector development. As
the R-squared measure may be mechanically linked to the number of cross-sectional
observations, we also control for the log of the number of banks in each country.

3. Summary Statistics
In this section we describe our empirical results. Figure 1 shows the evolution of average bank
market power and bank systemic risk over the years 1996 to 2010. Both measures are initially
calculated at the bank-year level and then averaged by country on a yearly basis between 1996
and 2010. The plotted lines correspond to the yearly averages of these cross-country averages.
The pattern of time series changes in the Lerner index is comparable to that in Beck, De Jonghe,
and Schepens (2011), even though we only have publicly traded banks in our sample. The
Lerner index has been steadily increasing since 1999, suggesting a decline in bank competition
till the start of the financial crisis. The decline may have been due to increasing bank
consolidation and changes in informational technology which has increased fixed costs resulting
in larger scale economies. There has also been a continuous shift from traditional intermediation
to more complex financial products where price and quality are more opaque and products more
tailor made, which limit price competition in these markets. The Lerner index has declined after
the onset of the global financial crisis, perhaps driven by eroded bank profits during the time
period. Figure 1 also shows the evolution of our measure of systemic stability - the average R-
squared. Consistent with Anginer and Demirguc-Kunt (2011), we find an increase in systemic
risk leading up to the sub-prime financial crisis. The figure also indicates that overall there seems
to be a positive relation between bank market power and systemic risk, which we will examine
further in Section 3.1. There is pro-cyclicality in both pricing power and systemic risk over the

15
time period we study. One possible explanation is the fad-driven growth in non-traditional
banking activities and non-interest income during boom periods that are associated with
increases in systemic risk. Shleifer and Vishny (2010) build a model in which activities that the
bankers have less ‘skin in the game’ are overfunded when asset values are high which leads to
higher systemic risk. Brunnermeir, Dong and Palia (2012) find that non-interest income is pro-
cyclical and is associated with higher systemic risk. The non-traditional activities of banks have
also been associated with rapid development of new financial products such as credit default
swaps and collateralized debt obligations, which has increased the complexity of bank balance
sheets and also has created new channels of inter-dependency across these institutions. Increased
interconnections make the banking sector more vulnerable to economic, liquidity and
information shocks, increasing systemic risk. Although, in these activities banks compete with
other capital market intermediaries such as hedge funds and insurance companies, the non-
traditional intermediation requires great economies of scale. The complexity and opaqueness of
new financial products and the importance of counterparty risk (which can be reduced through
scale and implicit state guarantees) also limit price competition in these markets.
Panel A of Table 1 provides the summary statistics of variables used in this study. An
average bank in the sample has log total asset value of 8.19, non-deposit short term funding ratio
of 0.13, return on assets of 0.01, market-to-book ratio of 1.08, non-interest income share of 0.19,
provision to net interest income ratio of 0.18, and Lerner index of 0.18. These numbers are
comparable to those in previous studies in the literature.
Panel B of Table 1 shows the sample distribution by calendar year. The number of banks
increased markedly in 2001 as Bankscope increased its coverage of banks. In terms of country
coverage, we find that U.S. and Japan have the highest number of banks in the sample. While
U.S. and Japanese banks account for about 55% of our bank-year observations, our results are
robust to the exclusion of these banks. There are a handful of countries with very few bank year
observations. Since our measure of systemic risk can be affected by the number of bank
observations in each country-year, we also checked that our results are robust to excluding
countries with fewer than seven banks in any given year from our analyses, and confirmed that
the results are robust.
Panel A of Table 2 presents the Pearson correlations of bank level variables. The
univariate correlations suggest that larger banks, banks more reliant on non-deposit short term

16
funding, less profitable banks, banks with few growth opportunities as measured by their market-
to-book ratios, banks that have higher loan loss provisions to net interest income ratios, and
banks that have more market power as measured by Lerner index have higher systemic risk.
They also suggest that the two systemic risk measures, Logistic (RSQ) and ∆CoVar, are
significantly correlated with each other. They are also highly correlated with the total risk
measures of distance to default, and a traditional measure of bank soundness in the literature,
log(zscore), which is calculated as the log value of average bank return on assets (net income
divided by total assets) plus bank equity to assets ratio, scaled by the standard deviation of return
on assets over the previous five years. Riskier banks are also more likely to have higher systemic
risk.
Panel B of Table 2 presents the Pearson correlations for country level variables. We find
that countries with less competitive banking industries have more concentrated banking
industries, higher banking sector entry barriers, lower ratios of applications denied and lower
government ownership. These countries also tend to have higher GDP per capital, higher GDP
growth volatility, and more international trade. In addition, they have more stringent
requirements on bank capital, less credit information sharing and higher deposit insurance
coverage.

3.1. Competition and Systemic Stability: Baseline Results

In this section, we examine how bank competition affects systemic stability after controlling for
bank and country level variables. We use the following regression specification for our main
analyses:

riskijt = β0 + Ω×bank_controlsijt-1 + Θ×country_controlsjt-1 + β1×competitionijt-1 + αi + λt + εijt (13)

Our dependent variable is bank i’s systemic risk (in country j in year t), riskijt, and is
equal to the logistic transformation of R-squared from a regression of bank i’s weekly changes in
distance to default on country j’s average weekly changes in distance to default in year t
excluding bank i itself. Our main explanatory variable of interest is bank competition, measured
by the Lerner index. Bank level control variables include bank size, square term of bank size,
bank non-deposit short term funding, profitability, market-to-book ratio, non-interest income

17
share, provisions to net interest income ratio. We use bank size to control for economies of scale,
bank non-deposit short term funding to control for its funding structure, market-to-book ratio to
control for bank growth opportunities, non-interest income share to control for bank business
model, and provisions to control for bank loan risk. Country level control variables include
natural logarithm of GDP per capita, variance of GDP growth rate, imports plus exports of goods
and service divided GDP, private credit divided by GDP, and the log number of banks in each
country and year. All explanatory variables are lagged by one year. In the regression, we also
include bank fixed effects, αi, to control for time invariant bank heterogeneity and use calendar
year fixed effects, λt, to control for time varying global business cycle effects. We use bank
fixed effects estimations to mitigate the endogeneity concern that both bank competition and
systemic risk can be driven by omitted bank level variables which are relatively stable over time,
such as bank ownership structure.
Table 3 presents the coefficient estimates for the bank fixed effect regressions. Since our
control variables are correlated with each other, in Column (1) of Table 3, we only include the
Lerner index as explanatory variable for bank systemic risk. We find that the relationship
between Lerner index and bank systemic risk is both positive and statistically significant at the
1% level. The coefficient estimate indicates that a one standard deviation increase in competition
(i.e., a 0.2 unit decrease in the Lerner index) is associated with a 0.12 standard deviation
reduction in systemic risk. If we were to rank all banks according Lerner and systemic risk, a
bank that moves up a quintile in Lerner rankings, would move up close to one quintile in
systemic risk rankings.
In Column (2) of Table 3, we include the additional bank and country level variables as
controls in our regression. Column (2) of Table 3 shows that larger banks pose greater systemic
risk. Banks with higher market-to-book ratios have lower systemic risk, suggesting that the
availability of growth options reduces systemic risk. For country level variables, GDP growth
volatility is positively correlated with bank systemic risk, indicating higher bank risk taking in
these countries. We also find that international trade as captured by trade to GDP is associated
with lower systemic risk, suggesting that banks take more diversified risks in these countries.
Log number of banks is positively correlated with systemic risk, which is consistent with more
accurate estimation of systemic risk in countries with a larger number of banks. More

18
importantly, the relationship between Lerner index and bank systemic risk remains positive and
statistically significant.14
In Column (3), we include the squared term of size as an additional control variable to
allow for a nonlinear relationship between bank size and systemic risk. We find that the
coefficient for the square term of bank size is not statistically significant. Including squared term
of bank size does not affect either the economic magnitude or the significance level of the impact
of Lerner index on bank systemic risk. 15 Overall, the evidence in Table 3 suggests that
competition enhances stability.16
We also consider alternative measures of bank systemic risk and also measures of bank
total risk. The results are presented in Panel A of Table 4. First, Column (1) of Panel A reports
the regression results of ∆CoVar on Lerner index and control variables. We find a negative
relationship between Lerner and ∆CoVar, suggesting that competition reduces systemic risk. In
Column (2) of Panel A, we use bank distance to default as our measure of total risk. The results
suggest that bank market power also reduces bank distance to default and thus increases bank
total risk. In Column (3) of Panel A, we use log value of z-score to measure bank total risk,
where z-score is calculated as average bank return on assets (net income divided by total assets)
plus bank equity to assets ratio, scaled by the standard deviation of return on assets over a five-
year rolling window.17 In contrast to the results using distance to default as measure of bank total
risk, we find that Lerner is positively related to log value of z-score, which implies that
competition increases bank total risk. The results suggest that the use of z-score in studying the
relationship between bank risk and competition can be problematic, as both z-score and Lerner
index are calculated using bank balance sheet profitability measures.
Next, we examine whether our results are robust across different measures of
competition. We present the regression results in Panel B of Table 4. First, we use the H-statistic
as a measure of competition. The regression results in Column (1) of Panel B show that

14
We also compute the variance inflation factor (VIF) for our model estimates. VIF is equal to 1/(1-r2), where r2 is
from the regression of an independent variable on the remaining independent variables. The VIF for our Lerner
index is 4.33, suggesting that multicolinearity does not significantly affect our results.
15
We obtain quantitatively similar results for all our regressions in this paper if we include size squared as a control.
16
Our results are robust when we include the lagged value of systemic risk as an additional control variable. For
instance, in the baseline regression (as in column (3) of Table 3), after we control for the lagged value of systemic
risk, the coefficient for Lerner index is 1.618 (t-statistic = 5.18). The lagged variable of systemic risk itself has a
coefficient of 0.030 (t-statistic = 2.19).
17
We lose a number of observations in the regression because the calculation of z-score requires at least three years
of data in a five-year window.

19
competition as measured by the H-statistic reduces bank systemic risk. As alternative measures,
we use the three bank concentration ratio measured as the percentage of total assets held by top
three commercial banks in a given country and the Hirschmann-Herfindahl index. The
regression results using these measures are reported in Columns (2) and (3) of Panel B. Three-
bank concentration increases bank systemic risk, however, when we use the Hirschmann-
Herfindahl index measure of bank concentration, we find no significant relationship between
bank concentration and systemic risk. The results are consistent with recent studies that suggest
concentration measures may be poor proxies for bank competition (Claessens and Laeven
(2004)). We also consider the impact of three government policies that restrict competition on
bank systemic risk. Both higher government ownership of banks (Column (6) of Panel B) and
applications denied (Column (5) of Panel B) are associated with greater systemic fragility. The
coefficient on entry barriers (Column 4) of Panel B) is positive but statistically insignificant.
Overall, the evidence in Table 5 suggests that competition enhances stability.18

3.2. Competition, Regulation, and Systemic Stability

As we have shown in the previous section, competition has a positive impact on systemic
stability, consistent with the notion that competition incentivizes banks to take on more diverse
risks. The impact of lack of competition may depend on the larger institutional environment and
can potentially be mitigated through regulation. For instance, greater capital requirements and
activity restrictions may limit the extent to which banks can or will engage in correlated risk
taking activities in the absence of competition. Similarly, better investor protection and greater
information availability would facilitate better monitoring even in the absence of competition. In
this section, we examine how each country’s regulatory and institutional environment affect
bank systemic stability and whether it exacerbates or mitigates the positive relationship between
competition and systemic stability. We use the following regression specification:

18
For robustness, we re-estimate our baseline regression specification until the second quarter of 2008 and our
results still hold across all three competition variables (i.e., Lerner, H-statistic, and concentration). For instance, the
Lerner index has a coefficient of 1.204 (t-statistic = 3.38). When we split the sample into terciles by Lerner index
during the 2008Q3-2009 time period, we find that the systemic risk is indeed much higher (lower) in the tercile with
the higher (lower) Lerner index. The group with the lowest Lerner index has an average (median) systemic risk of -
2.677 (-2.101), the group with the median Lerner index has an average (median) systemic risk of -1.483 (-1.102),
and the group with the highest Lerner index has an average (median) systemic risk of -1.296 (-0.863).

20
 riskijt = β0 + Ω×bank controlsijt-1 + Θ×country controlsjt-1 + β1×competitionijt-1
(14)
+ β2×regulationjt-1 + β3×competitionijt-1×regulationjt-1 + αi + λt + εijt

As before, our dependent variable is bank i’s systemic risk (in country j in year t), riskijt.
We use the same controls as described in the previous section. The regression specification is
similar to what we used in equation (13) except that we now add in country level bank regulation
variables (regulation) and the interactions between country level regulation variables and the
Lerner index as additional explanatory variables.19 First we examine the impact of the regulation
variables without interaction terms. These baseline results are provided in Table 5. The results
with the competition interactions are provided in Table 6.

3.2.1. Bank Regulation, Supervision and Systemic Stability

Tables 5 and 6 present the coefficient estimates for bank fixed effects regressions with bank
regulation and supervision variables included as additional explanatory variables. The variables
we consider are activity restrictions, capital stringency, supervisory power and explicit asset
diversification guidelines provided by regulators.
Activity restrictions can reduce potential channels of credit risk contagion (Anginer and
Demirguc-Kunt 2011). However activity restrictions may also result in herding behavior and
greater correlated risk taking if the banks are unable to venture into new markets, or seek new
lines of businesses or clients. Stringent capital requirements would help minimize contagion and
may also incentivize bank investors to control systemic risk taking. Investors tend to prefer well
capitalized banks as these banks have a relatively higher incentive to monitor (Repullo 2004;
Allen, Carletti, and Marquez 2011). We would also expect greater supervisory power and
explicit guidelines for diversification to have a positive impact on systemic stability by
incentivizing banks to take on diverse risks.
The baseline results reported in Columns (1), (2), (3), and (4) of Table 5 suggest that this
is indeed the case. Except for activity restrictions all variables are negative and significant. As
before, we interact these supervision variables with the Lerner index. The regression results are
reported in Table 6. The coefficient on the interaction variable for the diversification guidelines

19
To make our results comparable to previous analyses, we continue to use bank fixed effects estimations. We
acknowledge that the lack of sufficient time series variation in regulatory variables and adding in interaction terms
between correlated variables (i.e., between Lerner index and regulatory variables) may weaken our results.

21
is negative (Column (4)), suggesting that the benefit in reducing systemic risk with
diversification guidelines is greater in less competitive markets. The other interaction terms
between Lerner and bank regulation measures are statistically insignificant (Columns (1) - (3)).

3.2.2. Private Monitoring and Systemic Risk

Next we examine the impact of private monitoring on systemic stability and on the competition-
stability relationship. The variables we consider are investor protection, depth of credit
information and deposit insurance. We expect greater monitoring and lower asymmetry in
information to be associated with lower systemic risk. First, better investor protection and
greater information availability facilitates monitoring. Second, information asymmetry provides
a potential channel in which shocks can be propagated through the banking system (a number of
papers have used constrained information asymmetry framework to explain risk contagion and
crises; see for instance Genotte and Leland 1990; Kodres and Pritsker 2002; Hong and Stein
2003; Barlevy and Veronesi 2003, Yuan 2005). If greater information availability provides a
substitute to competition in reducing systemic fragility, then we would expect the impact of
greater information to be stronger in less competitive markets. However, it is also possible that
information asymmetry affects stability through different channels than competition. For
instance, competition may incentivize banks to take on more diversified risks, while greater
information availability may help reduce contagion of a macro shock to the banking system.
The baseline results for investor protection and credit information depth are provided in
Columns (5) and (6) in Table 5. Consistent with our expectations, investor protection
significantly reduces systemic risk after controls. In Columns (5) and (6) of Table 6, we present
results from regressions including the interaction between private monitoring variables and the
Lerner index. The results indicate that the effect of investor protection and depth of credit
information in reducing systemic risk is lower in less competitive markets.
Deposit insurance has two offsetting effects on systemic stability. While deposit
insurance may prevent bank runs (Matutes and Vives 1996) and ensure systemic stability, it may
also lead to moral hazard and excessive bank risk taking (Demirguc-Kunt and Kane 2002;
Demirguc-Kunt and Huizinga 2004). Anginer, Demirguc-Kunt and Zhu (2012) show that the
effect of deposit insurance on systemic risk is negative during the crisis period, although over the
full sample period, the overall impact is still positive. Furthermore, generous safety nets tend to

22
be correlated with other implicit state guarantees. As Demirguc-Kunt and Detragiache (2002)
suggest, if funds are set aside to cover losses in the event of a crisis through a deposit insurance
fund, then bank creditors and possibly bank shareholders may be able to put pressure on the
policymakers to extend protection to their own claims. Consistent with this view, Demirguc-
Kunt and Huizinga (2004) find banks’ cost of funds to be lower and less sensitive to risk in
countries with explicit deposit insurance. If there is an implicit guarantee provided by the State
to cover losses stemming from a systemic crisis, banks will have incentives to take on correlated
risks (Acharya 2005). Guaranteed banks will not have incentives to diversify their operations,
since the guarantee takes effect only if other banks fail at the same time. Alternatively, banks
may be more likely to take correlated risks in order to receive government guarantees during a
systemic crisis, in the absence of deposit insurance. In Column (7) of Table 5, we include a
deposit insurance coverage ratio as an additional explanatory variable. In Column (7) of Table 6,
we include both the deposit insurance coverage ratio and the interaction between the Lerner
index and deposit insurance coverage ratio as additional explanatory variables. When included
with the competition variable, the main effect of deposit insurance on systemic stability is
positive and significant, suggesting that deposit insurance reduces systemic stability. The
interaction term is positive and significant, suggesting the adverse effect of deposit insurance on
incentives is more pronounced in less competitive markets.

3.3. Robustness Checks

In Panel A of Table 7, we consider three alternative regression specifications. First, we
use country fixed effect regression to control for country heterogeneity while also controlling for
year fixed effects. The regression results are presented in Column (1) of Panel A. The
relationship between Lerner index and bank systemic risk is still positive and statistically
significant. Second, we follow Beck, De Jonghe, and Schepens (2011) and use a time varying
country fixed effect to capture time varying country-specific regulation or business cycle effects
on systemic risk of banks. The coefficient estimates in Column (2) of Panel A show a
statistically significant positive relationship between the Lerner index and systemic risk. In
Column (3) of Panel A, we use ordinary least squares (OLS) estimation and still find a positive
relationship between Lerner index and bank systemic risk. In Column (4) of Panel A, we run a
two-stage least squares regression (2SLS) to deal with the potential endogeneity problem of

23
Lerner index. We follow Beck, De Jonghe, and Schepens (2011) and use cost to bank income
ratio, loan growth, and lagged lerner index as instruments. 20 The second stage coefficient
estimates again confirm a positive relationship between bank market power and systemic risk.21
We conclude that our results on bank competition and systemic risk are robust to these
alternative regression specifications.
We also conduct a battery of robustness checks using different sample selection criteria
such as excluding banks in USA and Japan, excluding bank-year observations prior to 2001,
dropping countries with fewer than seven banks, and including bank observations in 2010 (in the
aftermath of the recent crisis). The regression results are presented in Panel B of Table 7. Our
results are robust to these alternative sample selection criteria.
In unreported results, we also used a number of alternative measures for systemic
stability as a robustness check. We computed R-squared using equity returns instead of changes
in distance-to-default. When we repeat the regressions using the R-squared computed from
equity returns, we obtain similar results. We also conduct the regressions at the country level
using the logistic transformation of country average R-squared as our dependent variable and
country average Lerner index as main independent variable of interest. The results are also
qualitatively similar but not as statistically significant.22

4. Conclusion
Competition in the financial sector has a long list of benefits documented in the literature: greater
efficiency in the production of financial services, higher quality financial products and more
innovation. When financial systems become more open and contestable, generally this results in
greater product differentiation, a lowering of the cost of financial intermediation and more access
to financial services. But when we turn to the issue of financial stability, whether competition is
beneficial or not is still the subject of a continuing debate among academics and policymakers
alike.

20
Unreported first stage regression results and tests show that these instruments are both relevant and exogenous.
However, we acknowledge that such tests may have low power to reject the validity of instruments.
21
In unreported results, we follow Bruhn, Farazi, and Kanz (2012) and use the log value of 1 plus minimum capital
requirement for bank entry from the Barth, Caprio, and Levine surveys as our instrument for bank competition. The
second stage regression results confirm a positive relationship between Lerner index and bank systemic risk.
22
For instance, in our baseline country fixed effects regression of country average systemic risk on country average
Lerner index, we obtain a regression coefficient of 1.373 for the Lerner index and the coefficient is significant at the
10% level (p-value=0.095).

24
 In this paper we investigate the relationship between bank competition and systemic
stability, and using bank level measures of competition and co-dependence, we show a robust
positive relationship between the two. Whereas much of the extant literature has focused on the
relationship between competition and the absolute level of risk of individual banks, we examine
the correlation in the risk taking behavior of banks to capture systemic fragility. Our results
indicate that greater competition encourages banks to take on more diversified risks, making the
banking system less fragile to shocks.
We also examine the impact of the institutional and regulatory environment on systemic
stability and find that bank systemic risk is higher in countries with weak supervision and private
monitoring, greater government ownership of banks, and public policies that restrict competition.
Furthermore, lack of competition has a greater adverse effect on systemic stability in countries
with weak investor protections, generous safety nets and where the authorities provide limited
guidance for bank asset diversification.
Our paper has important policy implications. Unlike most of the earlier literature, our
findings suggest that market power is associated with greater systemic fragility, which suggests
the importance of ensuring a competitive environment in banking. However, our results also
stress the importance of the underlying regulatory and institutional framework. Allowing entry
(by rejecting fewer applications) reduces systemic fragility, but so do capital stringency
requirement and diversification guidelines, particularly in less competitive banking
environments. Our results also suggest that government ownership is directly associated with
higher systemic fragility.
Overall, our results lend support to the view that fostering the appropriate incentive
framework is very important for ensuring systemic stability. These incentives are shaped by the
design of entry and exit policies, existence and generosity of deposit insurance and safety net
policies, good prudential regulation, and availability of information. The fact that entry barriers,
supervisory power and private monitoring are all associated with lower bank systemic risk is also
consistent with the important role of both prudential regulation and market discipline in ensuring
stability.
In conclusion, it is important for the regulatory framework to strike the right balance
between curbing excesses while avoiding potential anti-competitive effects. Our results suggest
information availability, prudent capital requirements for entry as well as operation, and better

25
credit monitoring are the types of actions that would improve systemic stability. In contrast,
increases in regulatory costs that raise domestic and foreign entry barriers into the financial
sector make markets less contestable, depriving countries of many of the benefits of an efficient
and innovative banking system, as well as leading to greater fragility.

26
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30
Figure 1: Evolution of bank competition and systemic risk over time: 1996-2009
This figure shows the evolution of Lerner index and the R-squared over the sample period. Both measures are
initially calculated at the bank-year level and then averaged by country on a yearly basis between 1996 and 2010.
The plotted lines correspond with the yearly averages of these cross-country averages.

32
Table 1: Summary statistics
To be included in the sample, we require a bank to have stock price information from Compustat Global/CRSP and
financial information from Bankscope. Definitions of variables are in Appendix I. Panel A presents the summary
statistics of all variables used in this study. Panel B reports the sample distribution by calendar year.

Panel A: Summary statistics

Variables N P25 Mean Median P75 STD

Logistic (RSQ) 15,294 -3.844 -2.505 -2.150 -0.830 2.453
ȴCoVar 14,779 -0.122 -0.049 -0.033 0.046 0.232
Distance to Default 15,668 3.523 5.452 4.946 6.900 2.616
Log (zscore) 11,149 2.674 3.442 3.528 4.291 1.301
Year 15,668 2,001 2,004 2,004 2,007 3
Lerner 12,615 0.114 0.176 0.196 0.276 0.205
H-statistic 15,563 0.403 0.423 0.437 0.448 0.108
Concentration 15,598 0.277 0.455 0.371 0.603 0.220
HHI 14,859 0.004 0.047 0.013 0.081 0.060
Log (Total Assets) 14,866 6.676 8.191 7.986 9.561 2.007
Non-Deposit ST Funding 14,417 0.000 0.133 0.031 0.120 0.258
ROA 15,639 0.004 0.013 0.009 0.015 0.031
Market to Book Ratio 14,865 0.994 1.084 1.037 1.105 0.217
Non-Interest Income Share 14,616 0.058 0.190 0.123 0.234 1.906
Provisions 13,979 0.036 0.181 0.091 0.204 0.335
Log (GDP Per Capita) 15,307 9.703 9.765 10.400 10.517 1.248
GDP Growth Volatility 15,307 0.932 2.095 2.088 3.191 2.353
Trade / GDP 15,208 24.672 56.009 30.977 64.776 57.410
Private Credit / GDP 14,945 0.898 1.308 1.445 1.733 0.577
Log (Number of Banks) 15,668 2.795 4.297 3.958 6.197 1.713
Entry Barrier 15,363 7.000 7.397 8.000 8.000 0.854
Application Denied 14,116 0.000 0.079 0.000 0.014 0.197
Government Owned 15,260 0.000 0.083 0.000 0.093 0.167
Activity Restriction 15,363 8.000 8.119 8.000 9.000 1.934
Capital Stringency 15,363 5.000 5.213 5.000 6.000 1.075
Supervisory Power 15,363 10.000 11.756 13.000 13.000 2.419
Diversification Index 15,363 1.000 1.384 1.000 2.000 0.563
Investor Protection 4,387 5.700 6.804 7.000 8.300 1.595
Credit Information Depth 5,907 4.000 4.969 6.000 6.000 1.489
Coverage Ratio 12,864 2.106 8.509 8.363 8.675 62.064

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Panel B: Sample distribution

Year Frequency Percent

1997 667 4.26
1998 728 4.65
1999 849 5.42
2000 892 5.69
2001 1,104 7.05
2002 1,150 7.34
2003 1,337 8.53
2004 1,466 9.36
2005 1,485 9.48
2006 1,540 9.83
2007 1,514 9.66
2008 1,507 9.62
2009 1,429 9.12

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Table 2: Correlation tables
To be included in the sample, we require a bank to have stock price information from Compustat Global/CRSP and financial information from Bankscope. Definitions of variables
are in Appendix I. Panel A presents the correlation matrix of bank level variables. Panel B presents the correlation matrix of country level variables. In parentheses below the
correlations are their corresponding p-values.

Panel A: Correlation matrix of bank level variables

a (Logistic (RSQ)) b c d e f g h i j
b ∆CoVar -0.096
(0.000)
c Distance to Default -0.050 0.018
(0.000) (0.033)
d Log (zscore) -0.069 0.046 0.194
(0.000) (0.000) (0.000)
e Lerner 0.054 -0.030 0.064 0.334
(0.000) (0.001) (0.000) (0.000)
f Log (Total Assets) 0.362 -0.049 0.201 -0.062 0.012
(0.000) (0.000) (0.000) (0.000) (0.185)
g Non-Deposit ST Funding 0.019 -0.005 -0.108 -0.146 0.030 0.096
(0.024) (0.517) (0.000) (0.000) (0.001) (0.000)
h ROA -0.023 -0.008 0.057 0.057 0.589 -0.155 0.091
(0.005) (0.314) (0.000) (0.000) (0.000) (0.000) (0.000)
i Market to Book Ratio -0.084 -0.001 -0.119 0.030 0.253 -0.128 0.091 0.366
(0.000) (0.869) (0.000) (0.002) (0.000) (0.000) (0.000) (0.000)
j Non-Interest Income Share 0.002 -0.009 0.016 -0.013 0.001 -0.004 0.023 0.044 0.028
(0.776) (0.280) (0.051) (0.172) (0.921) (0.645) (0.005) (0.000) (0.001)
k Provisions 0.039 0.001 -0.048 -0.330 -0.440 0.138 0.052 -0.288 -0.087 0.033
(0.000) (0.930) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

35
Panel B: Correlation matrix of country level variables

a (Lerner) b c d e f g h i j k l m n o p q r
b Negative H-statistic -0.018
(0.636)
c Concentration 0.124 -0.033
(0.001) (0.399)
d HHI 0.158 -0.098 0.385
(0.000) (0.011) (0.000)
e Entry Barrier 0.116 0.028 0.020 -0.043
(0.002) (0.473) (0.601) (0.267)
f Application Denied -0.068 0.120 -0.070 0.111 0.038
(0.094) (0.004) (0.079) (0.008) (0.340)
g Government Owned -0.232 0.016 -0.315 -0.094 -0.159 0.330
(0.000) (0.698) (0.000) (0.019) (0.000) (0.000)
h Log (GDP Per Capita) 0.096 -0.007 0.274 -0.177 -0.052 -0.519 -0.453
(0.010) (0.867) (0.000) (0.000) (0.165) (0.000) (0.000)
i GDP Growth Volatility 0.309 -0.047 -0.042 0.057 -0.079 -0.017 0.168 -0.029
(0.000) (0.223) (0.253) (0.140) (0.034) (0.669) (0.000) (0.428)
j Trade / GDP 0.102 0.036 0.246 0.105 0.085 -0.080 -0.279 0.208 0.041
(0.008) (0.359) (0.000) (0.007) (0.025) (0.046) (0.000) (0.000) (0.274)
k Private Credit / GDP -0.053 0.065 0.118 -0.411 -0.049 -0.321 -0.359 0.646 -0.194 0.274
(0.172) (0.106) (0.002) (0.000) (0.207) (0.000) (0.000) (0.000) (0.000) (0.000)
l Log (Number of Banks) -0.057 0.194 -0.392 -0.564 -0.006 -0.066 -0.016 0.182 -0.016 -0.134 0.442
(0.127) (0.000) (0.000) (0.000) (0.879) (0.096) (0.663) (0.000) (0.654) (0.000) (0.000)
m Activity Restriction 0.051 -0.051 -0.283 0.010 -0.091 0.035 0.165 -0.185 0.039 -0.214 -0.202 0.089
(0.183) (0.196) (0.000) (0.789) (0.014) (0.378) (0.000) (0.000) (0.304) (0.000) (0.000) (0.016)
n Capital Stringency 0.177 0.013 0.083 0.071 0.020 -0.049 -0.095 0.008 -0.026 -0.039 0.050 0.059 0.074
(0.000) (0.735) (0.026) (0.071) (0.584) (0.218) (0.012) (0.840) (0.495) (0.307) (0.196) (0.111) (0.046)
o Supervisory Power -0.002 0.019 -0.234 -0.031 0.183 0.157 0.095 -0.261 0.004 -0.014 -0.115 0.049 0.141 -0.026
(0.964) (0.627) (0.000) (0.427) (0.000) (0.000) (0.012) (0.000) (0.922) (0.714) (0.003) (0.187) (0.000) (0.485)
p Diversification Index -0.052 -0.066 0.061 -0.022 -0.019 0.062 -0.042 0.113 0.117 0.086 0.025 0.023 -0.279 0.028 0.071
(0.178) (0.095) (0.103) (0.579) (0.606) (0.118) (0.270) (0.002) (0.002) (0.024) (0.522) (0.543) (0.000) (0.447) (0.058)
q Invetor Protection -0.066 -0.001 0.011 -0.165 -0.160 -0.132 -0.207 0.225 -0.117 0.357 0.295 0.241 -0.050 0.053 0.023 0.152
(0.375) (0.992) (0.878) (0.027) (0.026) (0.077) (0.004) (0.002) (0.107) (0.000) (0.000) (0.001) (0.490) (0.463) (0.750) (0.034)
r Credit Information Depth -0.145 -0.076 0.020 -0.304 -0.121 -0.352 -0.185 0.560 -0.046 0.047 0.404 0.150 -0.266 -0.170 -0.164 0.177 0.320

36
 (0.022) (0.245) (0.754) (0.000) (0.051) (0.000) (0.003) (0.000) (0.465) (0.458) (0.000) (0.015) (0.000) (0.006) (0.008) (0.004) (0.000)
s Coverage Ratio 0.113 0.095 -0.005 -0.051 0.072 0.122 -0.093 -0.016 -0.018 -0.069 -0.127 -0.143 -0.120 -0.069 -0.023 0.121 -0.020 0.168
(0.010) (0.038) (0.901) (0.264) (0.095) (0.006) (0.034) (0.708) (0.675) (0.111) (0.004) (0.001) (0.005) (0.110) (0.591) (0.005) (0.815) (0.020)

37
Table 3: Competition and systemic risk: baseline results
Regression results of model Logistic(RSQ)ijt = β0 + Ω×bank_controlsijt-1 + Θ×country_controlsjt-1 +
β1×competitionijt-1 + αi + λt + εijt. Definitions of all variables are listed in Appendix I. Standard errors are reported in
parentheses below their coefficient estimates and adjusted for both heteroskedasticity and within correlation
clustered at the bank level. *** (**) (*) indicates significance at 1% (5%) (10%) two tailed level, respectively.

Variables (1) (2) (3)

Lerner 1.418*** 1.491*** 1.462***

(0.183) (0.285) (0.286)
Log (Total Assets) 0.262*** 0.676**
(0.100) (0.287)
Log (Total Assets) Squared -0.026
(0.017)
Non-Deposit ST Funding 0.235 0.226
(0.438) (0.437)
ROA 1.066 1.357
(2.547) (2.558)
Market to Book Ratio -0.740** -0.750**
(0.297) (0.298)
Non-Interest Income Share -0.018 -0.018
(0.019) (0.019)
Provisions 0.068 0.063
(0.112) (0.112)
Log (GDP Per Capita) -1.480 -1.293
(0.907) (0.915)
GDP Per Capita Growth 0.042*** 0.041**
(0.016) (0.016)
Trade / GDP -0.005** -0.005**
(0.002) (0.002)
Private Credit / GDP -0.036 -0.026
(0.204) (0.205)
Log (Number of Banks) 1.218*** 1.187***
(0.183) (0.185)
Constant -1.896*** 5.889 2.669
(0.070) (8.529) (8.801)

Observations 12,465 10,781 10,781

R-squared 0.427 0.445 0.445

38
Table 4: Competition and systemic risk: additional results
Regression results of model riskijt = β0 + Ω×bank_controlsijt-1 + Θ×country_controlsjt-1 + β1×competitionijt-1 + αi + λt
+ εijt, where riskijt is ∆CoVar in column (1) of Panel A, distance to default in column (2) of Panel A, log value of
zscore in column (3) of Panel A, and Logistic(RSQ)ijt in Panel B. Definitions of all variables are listed in Appendix
I. Standard errors are reported in parentheses below their coefficient estimates and adjusted for both
heteroskedasticity and within correlation clustered at the bank level. *** (**) (*) indicates significance at 1% (5%)
(10%) two tailed level, respectively. The coefficients for control variables are suppressed for brevity.

Panel A: Alternative measures of risk

(1) (2) (3)
Variables ∆CoVar Distance to Default Log (zscore)

Lerner -0.007** -0.685*** 1.332***

(0.003) (0.264) (0.176)

Observations 10,909 10,914 8,018

R-squared 0.530 0.737 0.712
Panel B: Alternative measures of competition
Variables (1) (2) (3) (4) (5) (6)

Negative H-statistic 0.246**

(0.103)
Concentration 2.685***
(0.411)
HHI -1.367
(1.922)
Entry Barrier 0.026
(0.081)
Application Denied 1.317***
(0.232)
Government Owned 1.070*
(0.575)

Observations 11,867 12,144 11,908 12,036 11,370 11,978

R-squared 0.460 0.464 0.459 0.461 0.469 0.464

39
Table 5: Relationship between systemic risk and regulation, supervision and private monitoring
Regression results of model Logistic(RSQ)ijt = β0 + Ω×bank controlsijt-1 + Θ×country controlsjt-1 + β1× ×regulationjt-1 + αi + λt + εijt. Definitions of all variables
are listed in Appendix I. Standard errors are reported in parentheses below their coefficient estimates and adjusted for both heteroskedasticity and within
correlation clustered at the bank level. *** (**) (*) indicates significance at 1% (5%) (10%) two tailed level, respectively. The coefficients for control variables are
suppressed for brevity.

Variables (1) (2) (3) (4) (5) (6) (7)

Regulation and Supervision

Activity Restriction -0.002
(0.027)
Capital Stringency -0.122***
(0.039)
Supervisory Power -0.064**
(0.026)
Diversification Index -0.297***
(0.077)
Private Monitoring
Investor Protection -0.492**
(0.236)
Credit Information Depth -0.070
(0.099)
Coverage Ratio -0.000
(0.000)

Observations 12,036 12,036 12,036 12,036 3,482 4,675 10,736

R-squared 0.461 0.462 0.462 0.463 0.688 0.612 0.460

40
Table 6: Competition and regulation interactions
Regression results of model Logistic(RSQ)ijt = β0 + Ω×bank controlsijt-1 + Θ×country controlsjt-1 + β1× ×regulationjt-1 + αi + λt + εijt. Definitions of all variables
are listed in Appendix I. Standard errors are reported in parentheses below their coefficient estimates and adjusted for both heteroskedasticity and within
correlation clustered at the bank level. *** (**) (*) indicates significance at 1% (5%) (10%) two tailed level, respectively. The coefficients for control variables are
suppressed for brevity.

Variables (1) (2) (3) (4) (5) (6) (7)

Lerner 2.483*** 0.070 -0.088 2.910*** -7.528*** -1.838 0.768*

(0.770) (0.916) (0.986) (0.528) (2.187) (1.320) (0.422)
Regulation and Supervision
Activity Restriction 0.011
(0.032)
Lerner × Activity Restriction -0.134
(0.094)
Capital Stringency -0.132**
(0.056)
Lerner × Capital Stringency 0.268
(0.169)
Supervisory Power -0.089***
(0.031)
Lerner × Supervisory Power 0.133
(0.082)
Diversification Index -0.064
(0.102)
Lerner × Diversification Index -1.137***
(0.347)
Private Monitoring
Investor Protection -0.394
(0.442)
Lerner × Investor Protection 1.201***
(0.285)
Credit Information Depth -0.315**
(0.128)
Lerner × Credit Information Depth 0.646***
(0.216)

41
Coverage Ratio 0.064***
(0.021)
Lerner × Coverage Ratio 0.120**
(0.047)

Observations 10,641 10,641 10,641 10,641 3,077 4,139 9,463

R-squared 0.445 0.446 0.446 0.448 0.678 0.594 0.440

42
Table 7: Competition and systemic risk: robustness checks
Panel A reports regression results of model Logistic(RSQ)ijt = β0 + Ω×bank_controlsijt-1 + Θ×country_controlsjt-1 +
β1×competitionijt-1 + εijt. Definitions of all variables are listed in Appendix I. Standard errors are reported in
parentheses below their coefficient estimates and adjusted for both heteroskedasticity and within correlation
clustered at the country level in column (1), at the country-year level in column (2), and at the country level in
columns (3) and (4). Column (1) reports results for country fixed effects regressions. Column (2) presents country-
year fixed effects regression results. Column (3) reports OLS regression results. Column (4) reports second stage
coefficient estimates from a two-stage least squares (2SLS) regression, where we use cost to income ratio, loan
growth, and lagged Lerner index as instruments for Lerner index in the first stage. *** (**) (*) indicates significance at
1% (5%) (10%) two tailed level, respectively. Panel B presents regression results of model Logistic(RSQ)ijt = β0 +
Ω×bank_controlsijt-1 + Θ×country_controlsjt-1 + β1×competitionijt-1 + αi + λt + εijt, Definitions of all variables are
listed in Appendix I. Standard errors are reported in parentheses below their coefficient estimates and adjusted for
both heteroskedasticity and within correlation clustered at the bank level. *** (**) (*) indicates significance at 1%
(5%) (10%) two tailed level, respectively. Column (1) excludes banks in USA and Japan. Column (2) excludes
bank-year observations prior to 2001. Column (3) drops countries with fewer than seven banks. Column (4) includes
bank-year observations in 2010. The coefficients for control variables are suppressed for brevity.

Panel A: Alternative estimation methods

Variables (1) (2) (3) (4)

Lerner 1.235*** 1.194*** 1.143*** 1.225***

(0.233) (0.456) (0.349) (0.375)

Year Fixed Effects Yes Yes Yes Yes

Country Fixed Effects Yes No No No
Country × Year Fixed Effects No Yes No No
Bank Fixed Effects No No No No
IV No No No Yes
Observations 10,781 10,781 10,781 9,710
R-squared 0.281 0.414 0.210 0.220
Panel B: Alternative sample
selection criteria
Variables (1) (2) (3) (4)
Countries with fewer
than
USA and Japan Prior to 2001 seven banks 2010
excluded excluded Excluded Included
Lerner 0.908** 1.395*** 1.649*** 1.189***
(0.361) (0.330) (0.292) (0.239)

Observations 4,932 8,778 9,970 11,579

R-squared 0.462 0.463 0.451 0.440

43
Appendix I. Variable definitions

Variables Definitions
Dependent variables
Logistic (RSQ) Logistic transformation of rsq (i.e.. log(rsq/(1-rsq))) , where rsq is r-
squared from a regression of weekly change in distance to default on
country average weekly change in distance to default (excluding the bank
in question) by year.
∆CoVar Change in the VaR of the system when the institution is at the 1%
percentile minus the VaR of the system when the institution is at the 50%
percentile.
Distance to default The difference between the asset value of a firm and the face value of its
debt scaled by the standard deviation of the firm’s asset value, calculated
from the Merton (1974) model.
Log(zscore) Log value of zscore, where zscore is the average bank return on assets (net
income divided by total assets) plus bank equity to assets ratio, scaled by
the standard deviation of return on assets over the previous five years.
Bank level control variables
Log (Total Assets) Log value of total assets in millions of US dollars.
Market to Book Ratio Market value of equity plus book value of debt, divided by book value of
total assets.
Provisions Loan loss provisions divided by net interest income.
Non-Interest Income Share Non-interest income divided by total operating income.
Non-Deposit ST Funding Non-deposit short term funding divided by the sum of deposits and non-
deposit short term funding).
ROA Net income divided by total assets.
Competition variables
Lerner Lerner index is equal to the difference between asset price and marginal
cost, normalized by asset price.
H-statistic H-statistic is calculated as the sum of the elasticity of revenue with respect
to three input prices.
Concentration Assets of three largest banks as a share of assets of all commercial banks.
HHI Hirschmann-Herfindahl index of concentration of total assets, which is the
sum of the squares of the market shares (assets) of each bank in each
country.
Country level variables
Competition
Entry Barrier Requirement on entry into banking, which is a variable constructed based
on eight questions regarding required submission to obtain a banking
license. The variable ranges from zero (low entry barrier) to eight (high
entry barrier). The eight questions on the items that are legally required to
be submitted before issuance of the banking license are as follows
(Yes=1/No=0): 1. Draft by-laws? 2. Intended organization chart? 3.
Financial projections for first three years? 4. Financial information on
main potential shareholders? 5. Background/experience of future
directors? 6. Background/experience of future managers? 7. Sources of
funds to be disbursed in the capitalization of new banks? 8. Market
differentiation intended for the new bank?
Application Denied The percentage of applications to enter banking denied in the past five
years.
Government Owned The fraction of banks that are 50% or more owned by the government.
Log (1+ Minimum capital requirement) Log value of one plus the minimum amount of capital needed by banks
for entry, in millions of USD.
Deposit insurance
Coverage Ratio Deposit insurance coverage ratio, which is deposit insurance coverage

44
 divided by deposits per capita. Set to 1 if a country offers full coverage.
Supervision
Activity Restriction A variable that ranges from zero to twelve, with twelve indicating the
highest restrictions on bank activities. The activity restrictions include
restrictions on securities activities, insurance activities, and real estate
activities. A value of 1 is added to the index if an activity is unrestricted, 2
if it is permitted, 3 if it is restricted, and 4 if it is prohibited.
Capital Stringency A variable that captures both the overall capital stringency and the initial
capital stringency based on answers to eight questions. It ranges from zero
to eight, with a higher value indicating higher capital stringency. For each
of the following eight questions, a value of 1 is added to the index if the
answer is yes: 1. Is the minimum capital-asset ratio requirement risk
weighted in line with the Basel guidelines? 2. Does the minimum ratio
vary as a function of market risk? 3. Are market values of loan losses not
realized in accounting books deducted? 4. Are unrealized losses in
securities portfolios deducted? 5. Are unrealized foreign exchange losses
deducted? 6. Are the sources of funds to be used as capital verified by the
regulatory/supervisory authorities? 7. Can the initial disbursement or
subsequent injections of capital be done with assets other than cash or
government securities? 8. Can initial disbursement of capital be done with
borrowed funds?
Supervisory Power A variable that ranges from zero to fourteen, with fourteen indicating the
highest power of the supervisory authorities. For each of the following
fourteen questions, a value of 1 is added to the index if the answer is yes:
1. Does the supervisory agency have the right to meet with external
auditors to discuss their report without the approval of the bank? 2. Are
auditors required by law to communicate directly to the supervisory
agency any presumed involvement of bank directors or senior managers in
illicit activities, fraud, or insider abuse? 3. Can supervisors take legal
action against external auditors for negligence? 4. Can the supervisory
authority force a bank to change its internal organizational structure? 5.
Are off-balance sheet items disclosed to supervisors? 6. Can the
supervisory agency order the bank's directors or management to constitute
provisions to cover actual or potential losses? 7. Can the supervisory
agency suspend the directors' decision to distribute: a) dividends? b)
bonuses? c) management fees? 8. Can the supervisory agency legally
declare-such that this declaration supersedes the rights of bank
shareholders-that a bank is insolvent? 9. Does the banking Law give
authority to the supervisory agency to intervene that is, suspend some or
all ownership rights-a problem bank? 10. Regarding bank restructuring
and reorganization, can the supervisory agency or any other government
agency do the following: a) supersede shareholder rights? b) remove and
replace management? c) remove and replace directors?
Diversification Index A variable that ranges from zero to two, with higher values indicating
more diversification. For each of the questions, a value of 1 is added to
the index if the answer is yes: 1. Are there explicit, verifiable, and
quantifiable guidelines regarding asset diversification? 2. Are banks
permitted to make loans abroad?
Private monitoring
Investor Protection A variable that ranges from zero to ten, with higher values indicating
stronger investor protection. The strength of investor protection index is
the average of the extent of disclosure index, the extent of director
liability index and the ease of shareholder suits index. The extent of
disclosure index includes who can approve related party transactions and
the disclosure requirements in case of related party transactions. The
extent of director liability index covers the ability of shareholders to hold

45

Credit Information Depth
Country level control variables
Log (Number of Banks)
Log (GDP Per Capita)
GDP Growth Volatility
Trade / GDP
Private Credit / GDP
interest parties and members of the approving body liable in case of
related party transactions, available legal remedies (damages, repayment
of profits, fines and imprisonment), and ability of shareholders to sue
directly or derivatively. The ease of shareholder suits index measures
direct access to internal documents of the company and use of a
government inspector without filing suit in court.
A variable that ranges from zero to six, with higher values indicating
deeper credit information. A value of 1 is added to the index when a
country’s reporting system has each of these characteristics: (1) both
positive and negative information are distributed; (2) data on both firms
and individuals are distributed; (3) besides data from financial institutions,
data from retailers and utility companies are also distributed; (4) more
than two years of historical data are distributed; (5) Data on loans below
1% of income per capita are distributed; and (6) laws guarantee borrowers
the right to inspect their data in the largest registry in the economy.
Log number of banks used to calculate country average weekly change in
distance to default.
Log value of GDP per capital in nominal constant US 2000 dollars.
Variance of GDP growth for the previous five years.
Imports plus exports of goods and services as a percentage of GDP.
Private credit by deposit money banks and other financial institutions to
GDP.
46