The Role of Banking Concentration on Financial Stability

Abstract

Globally, financial instability is a major source of concern among policy makers and bank regulators, particularly after the 2007-09 global financial crisis. Motivated by inconsistent theoretical evaluations on the impact of bank concentration on the likelihood of a systemic banking crisis, this paper investigates the role of bank concentration on financial stability in Kenya with competition as an intervening variable. The novelity of this study lies on the use of structural equation modeling (SEM) in the analysis of direct and indirect effects of bank concentration on financial stability. Results show that higher concentration induces banks to increase cost of service provision which may aggravate credit risks and expose banks to systemic risks. Further, competition plays a significant role in ensuring financial system stability which supports the ‘competition-stabiliy’ hypothesis. Uncompetitive banking industry may therefore provide incentive for banks to take excessive risks, which renders them vulnerable to systematic risks. We also establish that tight regulations enhances concentration and financial stability but hinders competition. These new insights give bank regulators and policy makers an incentive to formulate and implement the right policies to improve financial stability.