The impact of competition on bank risk-taking in sub-Saharan Africa

May 2018
By Teboho Bosiu

1 Introduction

According to the macroeconomic theory of aggregate demand, low real interest rates imply a low cost of borrowing for firms, which encourages them to increase the level of investment in the economy, and thus improve the aggregate demand. The financial sector plays a major role in ensuring that resources are efficiently transferred from surplus to deficit units. In this way, the development of the financial sector, particularly the banking sector, has the potential to benefit all sections of the population, and contribute immensely to economic growth. The financial sector in sub-Saharan Africa (SSA) is, however, generally underdeveloped, with over 80% of adults unbanked in 2010 (Mlachila et al. 2013). Mlachila et al. further note that the scale of financial intermediation in SSA remains significantly lower than in other developing regions of the world, with small and medium enterprises typically tightly constrained in their access to any form of credit, and most banking systems characterized by low loan-to-deposit ratios. Lending is mainly short-term in nature, with about 60% of loans having a maturity of less than one year. These characteristics are the result of, amongst other factors, low income levels, large informal sectors, low levels of financial literacy, weak contractual frameworks for banking activities, weak creditor rights, judicial enforcement mechanisms, and political risk (Mlachila et al. 2013).

In light of these features and impediments, it is undisputable that sub-Saharan Africa needs to take measures to accelerate financial sector development if it is to realize its maximum potential economic growth. Some commentators even call for the deregulation of the banking sector, to promote competition and facilitate the spread of new technologies, and thereby increase the share of the population with access to banking facilities – especially access to credit by small and medium enterprises. The high proportion of total assets accounted for by the three largest banks of SSA indicates that the market structures are typically oligopolistic, with high operational costs, interest rates and service fees (Mlachila et al. 2013). Moreover, some banking sectors in SSA are characterized by significant barriers to entry for new rivals (Makhaya & Nhundu 2015).

There is, however, another view, which holds that the structure of the sub-Saharan Africa oligopolistic banking system is stable and has the potential to shield the economy against external global shocks. Moreover, the resilience of economic activity in sub-Saharan Africa during the 2008/2009 global financial crisis is due to the banking systems being well positioned to handle the financial turmoil, given their low leverage, generally healthy capitalization levels, ample liquidity, little reliance on external funding, and little exposure to toxic financial assets (Mlachila et al. 2013). They came under pressure, but only slightly, indirectly via international trade linkages, as the global economic downturn fed into reduced exports and slower domestic economic growth, in turn adversely affecting borrowers and contributing to rising levels of nonperforming loans (NPLs). The impact of these developments on financial sector soundness in the region was relatively modest in the aggregate.

Motivated by those two views, as well as the features of financial services sector in SSA, the objective of this paper is to empirically investigate the nature of the relationship between the competition and risk-taking in the banking sectors of a number of countries in the region. Three main theories emerge from the extant literature: the franchise value paradigm, the risk-shifting paradigm, and the U-shaped relationship (Saurina Salas et al. 2007). The franchise value paradigm refers to the phenomenon of banks, if excessive competition exists in the banking industry, possibly adopting riskier policies to maximize profits and maintain their franchise value. The paradigm thus infers a positive relationship between competition and risk-taking. However, Boyd and De Nicoló (2005) contested the franchise value paradigm by suggesting that competition is negatively related to risk-taking. They argued that less competition will lead to high interest rates which could result in high default ratios through moral hazard and adverse selection, and thus increase instability. This is known as the risk-shifting paradigm.

These two paradigms appear to be models with very contradicting outcomes. The franchise value depicts a positive relationship, while the risk-shifting paradigm depicts a negative one. Martinez-Miera and Rapullo (2007) extended the risk-shifting paradigm model by allowing for imperfect correlation across individual firms’ default properties. They found a U-shaped relationship between competition and risk-taking. That is, as the number of firms increases, the likelihood of bank default first declines and then starts to increase once a certain threshold of competition has been reached. This paper, therefore, seeks to investigate which of these three relationships best explains the impact of competition on risk-taking in the sub-Saharan Africa banking system. That is, does an increase in competition lead banks to undertake riskier projects, leading to high risk exposure? Does less competition lead to high risk exposure as a result of moral hazard and adverse selection? Or does increased competition lead to decreasing levels of risk below a certain threshold and increasing levels of risk above that threshold? 

The rest of the paper is organized as follows. Section 2 briefly discusses the theoretical and empirical literature on this topic. Section 3 discusses the methodology employed. Section 4 discusses the data and descriptive statistics. Section 5 presents the results, and Section 6 concludes. Read more

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