Impact case study database

Prof. Philip Davis and Dr Dilruba Karim have a track record of extensive research in the areas of financial stability and financial regulation as well as on banking crises and their economic impacts (Ref. 1; Ref. 3; Ref. 5). Their research interests focus in particular on the links between banking competition and risks and financial stability (Ref. 2; Ref. 4; Ref. 6).

The banking sector is core to the economy but vulnerable to systemic failure, which can have detrimental economic consequences. Systemic risk was one of the main contributors to the 2008 financial crisis, which triggered severe instability in the economy and inaugurated a decade of fiscal austerity in the UK. This is why central banks and other regulators, both nationally and globally, are keen to improve their ways of monitoring and controlling banking sector risk.

However, current scholarship does not adequately address the nuances of the relationship between bank competition and risk, which are relevant for regulators who assess risks concerning financial stability. Prof. Davis and Dr Karim conducted research that addresses this gap and found both short-and long-run relationships between the competition and risk for banks from 27 EU countries (Ref. 2). Focusing on 2 6-year periods (pre- and post-2007), Prof. Davis and Dr Karim used 2 competition indicators: the H-statistic (which indicates the scope of competition in the country concerned) and the Lerner index (which indicates profit margins bank by bank). They found that both indicators have a positive short-run relationship with risk while long-run effects differ. These findings have important implications for policymaking, because they show that regulators should be cautious in the initial period after a rise in competition (because the indicators show an accompanying rise in bank risk). In the longer term, the likely impact of a given policy shift should be carefully considered (e.g. requiring a shift in certain macroprudential policies) (Ref. 2).

In 2017, the Bank of England commissioned Prof. Davis and Dr Karim to conduct research on bank leverage ratios (which is the relationship of bank capital to assets), competition, and risk globally (Grant 1). The Bank of England were in the process of introducing a minimum leverage ratio of 3% under the “Basel III” global agreement on bank regulation which adopted the leverage ratio as a prudential tool. As research on leverage ratios outside the US is limited, they commissioned Prof. Davis and Dr Karim to find out more about its potential effectiveness.

The research findings demonstrated a clear link between bank competition and institutional and sectoral risk, which had been widely disregarded by authorities, and in addition showed that the leverage ratio is an important indicator of bank risk (Ref. 4; Ref. 6). In more detail, the research assessed the effectiveness of a leverage ratio relative to the more commonly used regulatory risk-adjusted capital ratio (RAR) (which is used to measure a financial institution’s ability to withstand an economic downturn) in predicting individual bank risk in light of competition in the EU and the US (Ref. 4).

In addition to juxtaposing the leverage ratio with the RAR, Prof. Davis and Dr Karim used a dataset of national banking sectors to address a number of unresolved issues in the field of financial stability, which are significant for bank regulators (Ref. 6). Using macro data for approximately 120 countries globally, Prof. Davis and Dr Karim researched the signs of the relationship between bank competition and financial stability; the relation of capital adequacy of banks to risk; the nature of the relation between bank competition and bank capital; and the stability of advanced vs emerging market financial systems. The results detected a strong link between banking competition and crises, and showed that banking crises are more likely if there is a high level of competition, low leverage ratios or regulatory capital ratios, lower deposit/asset ratio, and a higher ratio of credit to assets (Ref. 6).