Financial Nexus: Efficiency and Soundness in Banking and Capital Markets

Financial Nexus: Efficiency and Soundness in Banking and Capital Markets

DOI: 10.4018/978-1-5225-9269-3.ch004


This book chapter investigates the financial nexus generated by bank soundness, concentration, and efficiency in the banking sector, as well as the development of the capital markets. The selected databases includes the time period between 1997 and 2010 for a large sample of 63 developed and developing countries. The empirical findings suggested that bank performance has a high impact on the relation between soundness, structural and functional characteristics of the banking sector. The econometric framework is complex and the empirical results appear to be robust for various measures of the selected variables and for distinct estimation techniques.
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Literature Review

The conventional approaches derived from industrial organization theory (Demsetz, 1973) suggest that competition increases the efficiency of banks. The structure–conduct–performance paradigm supposes that competitive large banks are more likely to implement better monitoring mechanisms and hence are less probable to suffer nonperforming loans (Hauswald & Marquez, 2003). Also, these banks are more able to extract monopolistic rents from concentrated markets as these rents are reflected by higher interest rates charged on loans and lower interest rates offered for deposits (see for instance Berger, 1995; Petersen & Rajan, 1995; Berger & De Young, 1997). However, recent research challenges this wisdom arguing that bank competition enhances the performance and stimulates the implementation of prudential mechanisms. Hence, current literature suggests a positive link between bank competition and soundness (Barth et al., 2004; Beck et al., 2006; Schaeck & Cihák, 2007, 2010; Carletti et al., 2007; Hauswald & Marquez, 2006). Schaeck and Čihák (2008, 2010) provide evidences that efficiency plays a key role in the transmission mechanism from competition to soundness. They argue that sound banks are abler to benefit from a competitive environment.

An alternative explanation relates to the efficient-structure hypothesis. According to this hypothesis, larger banks are abler to control their operating costs through better management and operational procedures and to transfer the various categories of risks. Such arguments may provide an explanation for the positive link between the degree of industry concentration and bank soundness (Hay & Liu, 1997; Beck, Demirgüç-Kunt, & Levine, 2006). As Bertay et al. (2011,.3) argue a bank’s absolute size thus represents a trade-off between bank risk and return. For an international sample of banks, they found that larger banks tend to be more profitable, while they also display a lower Z-score. The results from Ferreira (2012) point toward a point to a negative causation at the level of European Union running both from the concentration in banking sector to banks’ efficiency as well as from efficiency to concentration. Casu and Girardone (2006) found evidences that increased competition forced European Union’s banks to become more efficient, even though increased efficiency does not necessarily foster more competitive banking systems.

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