Deliver us from competition

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: Ricky Gervais, a comedian, tells a story about an anxious flight. When informed that the airline no longer offered newspapers to passengers, in order to cut costs, he found it all too easy to imagine a maintenance worker inspecting the plane’s undercarriage and asking: “Do we really need all these rivets?”

That firms which strive hard to sustain profits may act incautiously is a concern in many industries. The severity of today’s financial crisis is blamed by some on the pressure of competition on banks. There is a bulky academic literature that links liberalisation of markets with an increase in bank failures. It argues that the lifting of restraints, such as interest-rate caps on deposits or rules that prevent banks from operating in certain markets, leads to more intense competition. That is good for borrowers, but it also hurts banks’ profit margins by reducing the “franchise value” that comes from expected earnings.

A diminished franchise is not only bad for shareholders. By reducing the stake that banks have in their own long-term survival it may make bank failures more likely. A bank that could look forward to a stream of fat profits in a sheltered market would be careful to lend prudently to avoid a bankruptcy that would destroy the franchise. But a bank earning only lean and uncertain margins on garden-variety loans may have little to lose by gambling on riskier ventures. If these paid off, the bank would benefit. If they did not, depositors or government would pick up the bill.

This theory is backed by some empirical work. Research published in the American Economic Review in 1990 found that a measure of franchise values fell after restrictions were lifted on where banks could operate. Banks that lost market power as a consequence also held less capital as a buffer against bankruptcy. A more recent study by Vicente Salas, of the University of Zaragoza, and Jesús Saurina, director of the Bank of Spain’s financial-stability wing, found the same pattern in Spanish banking. Fewer restrictions spurred competition, squeezed profit margins and led to more risk-taking by banks. (Not all the evidence points this way: though these studies of individual markets indicate that competition can lead to fragility, international comparisons suggest the opposite, according to a survey last year for the World Bank by Thorsten Beck, now of Tilburg University.)