Central bankers and regulators tend to worry that too much competition in the financial sector increases instability and the risk of systemic failure. Competition authorities, on the other hand, tend to believe that the more competition, the better. Both can’t be right.

The UK’s Independent Commission on Banking has proposed ring-fencing retail activities from investment-banking activities in separately capitalised divisions of a bank holding company- Xavier Vives

There is a trade-off between competition and stability. Indeed, greater competitive pressure may increase the fragility of banks’ balance sheets and make investors more prone to panics. It may also erode the charter value of institutions.

A bank with thin margins and limited liability does not have much to lose, and will tend to gamble – a tendency that is exacerbated by deposit insurance and too-big-to-fail policies. The result will be more incentives to assume risk. Indeed, for banks close to the failure point in liberalised systems, the evidence of perverse risk-taking incentives is overwhelming.

That is why crises began to increase in number and severity after financial systems in the developed world started to liberalise in the 1970s, beginning in the United States. This new vulnerability stands in stark contrast to the stability of the over-regulated post-World War II period. The crises in the US in the 1980s (caused by the savings-and-loan institutions known as ‘thrifts’), and in Japan and Scandinavia in the 1990s, showed that financial liberalization without proper regulation induces instability.

In an ideal world, the competition-stability trade-off could be regulated away with sophisticated risk-based insurance mechanisms, credible liquidation and resolution procedures, contingent convertibles, and capital requirements with charges for systemic institutions. The problem is that regulation is unlikely to eliminate completely market failures: the competition-stability trade-off can be ameliorated, but not eliminated.

For example, the United Kingdom’s Independent Commission on Banking has proposed ring-fencing retail activities from investment-banking activities in separately capitalised divisions of a bank holding company. This is a compromise aimed at minimising the incentive to gamble with public insurance while allowing some economies of scale for banking activities.

But the devil is in the details, and, even in the most optimistic scenario, the trade-off between competition and stability will remain. One shortcoming of the measure consists in the fact that the crisis has hit both universal and specialised banks. Furthermore, the definition of the boundary between retail and investment-banking activities will leave an important grey area and generate perverse incentives.

And the regulatory boundary problem persists: risky activities may migrate to areas where regulation is lax and reproduce the problems with the shadow banking system that we have witnessed during the crisis. As a result, investment-banking operations might need to be rescued if they pose a systemic threat.

The massive regulatory failure exposed by the financial crisis that began in 2008 underscores the need to concentrate on reforms that provide the correct incentives to banks. But, if the past is any guide to the future, we should be aware of the limits of regulation.

The UK’s ICB has rightly stated that there is room to improve both competition and stability, given the current weak regulatory framework, but it would be imprudent to strive for the complete elimination of market power in banking.

The design of optimal regulation has to take into account the intensity of competition in the different banking segments. For example, capital charges should account for the degree of friction and rivalry in the banking sector, with tighter requirements in more competitive contexts.

It follows, then, that prudential regulation and competition policy in banking should be coordinated. This is all the more true in crisis situations, in which a protocol of collaboration should be implemented to delineate liquidity help from recapitalization, and to establish the conditions for restructuring in order to avoid competitive distortions.

What implications does this have for market structure? Concentration in well-defined deposit and loan markets is linked with competitive pressure. In more concentrated markets, banks tend to offer worse terms to customers. The crisis has affected both concentrated banking systems (for example, the UK and the Netherlands) and non-concentrated systems (e.g., the US and Germany).

In both cases, it has brought consolidation, leaving fewer players with increased market power and too-big-to-fail status. Witness the takeover by Lloyds TSB of the troubled HBOS (Halifax/Bank of Scotland) in the UK, or post-crisis consolidation in the US.

All this would not be so problematic if the increased market power of the merged institutions were a temporary reward for past prudent behaviour. In that case, the benefits would wane in importance as new competitors entered the banking fray. But if banks’ market power increases due to barriers to entry, consumers and investors will suffer.

An active competition policy will be needed. But the degree to which the authorities will be able to push for more competition in banking will depend crucially on the regulatory framework.

Let us fix and strengthen that framework, while bearing in mind that a simple mandate to maximise competitive pressure in banking is no more possible, or desirable, than one that would aim at eliminating instability completely.

© Project Syndicate, 2011, www.project-syndicate.org.

The author is professor of economics and finance at IESE Business School, University of Navarra.