Banking sector concentration, competition and financial stability: the case of the Baltic countries

This paper empirically assesses the potential nonlinear relationship between competition and bank risk for a sample of commercial banks in the Baltic countries over the period 2000-2014. Competition is measured by two alternative indexes, the Lerner index and the market share, while we consider the Z-score and loan loss reserves as proxies for bank risk. In line with the theoretical predictions, we find an inverse U-shaped relationship between competition and financial stability. This then means that above a certain threshold, the lack of competition is likely to exacerbate the individual risk-taking behaviour of banks, and could be detrimental to the stability of the banking sector in the Baltic countries. The threshold is around 0.60 for the Lerner index, and close to 50% for market share in terms of assets. The policy implications are that the existence of such a threshold suggests that the future evolution of the structure of the banking industry in these countries is of critical importance. Specifically, this implies that policy-makers should place greater emphasis on mergers and acquisitions to avoid any significant increase of banking sector concentration.