The removal of entry barriers in banking is one of the main aspects of the integration of financial markets that is taking place in many countries. In the European Union, the First and Second Banking Directives (1977, 1988), and recently the Financial Services Action Plan (1999) consisted of large sets of initiatives to ensure the full integration of European banking markets; also various deregulations at the national level have helped to foster banking integration.
Although most of the cross{border and cross{regional activities in Europe are taking place via mergers and acquisitions, there has been substantial de{novo entry in Portugal, Southern Italy, and in many of the Central and Eastern European accession countries (Barros (1995), Bonaccorsi di Patti and Gobbi (2001), Caviglia, Krause, and Thimann (2002)). In the United States, the removal of bank branch restrictions in the 1980s has led to significant entry by new banks and to improvements in the quality of loans (Jayaratne and Strahan (1996)), but also a greater number of bank failures (Keeley (1990)). However, the extent of de{novo entry in developed economies is regarded as quite limited, whereas developing economies (most notably Latin America and Eastern Europe) have attracted the most foreign bank entry (see Clarke, Cull, Martinez Peria, and Sanchez (2003)).
The purpose of this paper is to analyze the effects of entry deregulation on loan competition, bank stability and economic welfare. We consider a situation where a market that is served by banks with weak credit assessment is opened to entry by banks with better credit assessment facilities. Such entry, as expected, produces a better allocation of funds to borrowers, but it also increases banks' exposures to insolvency risk. The paper addresses the questions whether there is too much or too little entry relative to the social optimum, and how regulatory authorities can respond so as to guarantee bank stability after entry deregulation and to remove potential ineffciencies.
We consider a model of two markets (countries, states) that are identical in all respects except the degree of e±ciency of their banks' credit assessments. Each of these markets is populated by two types of borrowers (\good" and \bad"), and banks can be set up to conduct informative tests so as to single out good borrowers. Because there is both idiosyncratic and aggregate credit risk, banks with weak credit assessment ability fail with positive probability, whereas capital requirement regulation may be imposed to avoid bank failure. Banks possess market power because of a cost advantage in screening certain groups of borrowers due to geographical or technological specialization.
CONTENTS
Abstract
Non-technical summary
1 Introduction
2 The economic environment
3 The regulated economy
4 Financial market integration
5 The welfare effects of integration
6 Conclusions
Appendix
References
European Central Bank working paper series
