A Non-linear relationship between banking competition and risk-taking : an evidence from Indonesia

Abstract

On its activities, banks have to decide its stance toward risk while facing varying market structure and competitive pressure. Competition influences bank risk-taking, which in turn affect stability. Previous literatures are divided into two strands, competition-fragility and competition-stability. Competition-stability view states that competitive market would increase banking stability. In contrast, competition-fragility view purport that higher competition would hamper banking stability. Both of these views describe that bank risk-taking behavior respond differently toward changing competition level. We analyse panel data of 60 commercial banks in Indonesia from 2005 to 2017. Our study is classified into three parts. First, we assess the development of competition level in Indonesian banking industry using structural and non-structural approach. Second, as we believe that Indonesian banking competition are divided into several playing fields, we apply Cluster Analysis to distinct banks based on size and the intensity of intermediation function. Third, we analyze how competition affects bank risk-taking behavior in the context of decision making toward credit risk and liquidity risk. We allow for different responses from each bank group and quadratic responses of bank risk-taking toward the changing competitive environment. We found that the competition in Indonesian banking industry have a modest trend toward less competition. Observing in more detail, banking industry in Indonesia are classified into three groups: the leader, the niche, and the normal banks. We infer that each group faces different competitive environment. Our main finding suggests that there is a non-linear relationship between competition and bank risk-taking. An increase in competition, to some extent, would reduce bank risk-taking. However, after a certain point (e.g. Lerner Index of 0.544) more competition would induce higher risk-taking. The result sends a specific signal for Indonesian central bank to maintain competitive pressure on a certain level, as too much competition would disrupt banking stability.