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Title: Exploring the Conditional Effects of Market Power, Capital Adequacy and the Disciplining Role of Charter Value on Risk Taking Behavior of Banks: The Case of Pakistan
Authors: Rahman, Abdur
Keywords: Business Education
Issue Date: 2019
Publisher: Institute of Business Management, Karachi.
Abstract: Banking regulators and supervisory authorities aim to develop and exercise prudent policies to mitigate the riskiness of financial sector to achieve a stable banking system. In the banking literature, the tradeoff between competition and stability has resulted in predominantly two opposing views; the traditional view of competition-fragility argues that increased competition in banking erodes market power, reduces profit margins and charter value, which in turn encourage banks to take excessive risks. In contrast, the competition-stability view suggests that, low competition in banking results in more market power which may encourage the banks to charge higher loan rates adversely affecting borrowers by risk shifting mechanisms, exacerbating moral hazard and adverse selection issues. Given the opposing predictions of the literature, this study aims to test the two views, considering the effects of market power on the risk taking behavior of Pakistani banks along with the conditional effects of capital requirements, charter value and market discipline. Moreover, the literature has largely investigated the competition stability and or fragility nexus in deposit market only while ignoring the said nexus in loan market as a portfolio issue. We differentiate competition in deposit and loan markets for the first time in the case of Pakistan by estimating separate Lerner indices accordingly. In addition, we allow for possible non-linearities and explicitly test for charter value hypothesis, the risk shifting paradigm, the asset risk / leverage tradeoff effect and the capital buffer channels as potential channels for the risk effects of market power. Using annual data for an unbalanced panel of 30 banks from 2006 to 2017, this study adopts dynamic panel data analysis techniques of two step system GMM. To control for endogeneity and for robustness, the GMM is further augmented with instrumental variables. Our findings suggest that, the competitive conditions in lending and deposit markets are substantially and significantly different in the case of Pakistan. The lending market is highly monopolistic whereas the deposit market is highly competitive. In addition, the relationship between competition and stability is largely nonlinear whereby risk shifting paradigm is dominant in the deposit market whereas the asset risk / leverage tradeoff effect is supported in lending market. We also find that the 2 theoretical link between charter value and market power is sufficiently strong to restrain risky behavior of banks. At policy level, our findings suggest that infusing further competition into the deposit market may become detrimental to stability while the same is necessary to improve the competitive conditions in lending market. Furthermore, our results suggest thoroughly encouraging charter value and capital requirements as these two are strongly restraining risky behavior of banks. In addition, banks’ risk, capital regulations, charter value and market discipline are largely interconnected and should be taken as such that these mostly reinforce each other in lending market while behaves otherwise in deposit market. Thus banking regulators and supervisory authorities should be cognizant of the implications of unilateral policies.
Gov't Doc #: 20279
Appears in Collections:PhD Thesis of All Public / Private Sector Universities / DAIs.

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