Prudential regulation and competition policy: A question of balance?
Elena Carletti
Bocconi University, IEP and CEPR
OECD, 5 December 2025
A special thanks to Simone Boldrini (Bocconi University) for helping me prepare this talk
Rationale for prudential regulation
• Banks play a central role in the economy, but are inherently unstable
• Excessive risk in lending and runs on the liability side
• Bank failures can become systemic and cause large declines in economic activity
• Prudential regulation aims at preserving financial stability
• Ultimate goal: support lending and economic growth
• Main regulatory tools
• Micro-prudential: capital regulation, liquidity regulation, licensing
• Macro-prudential: capital buffers, borrower-based measures, etc.
Rationale for prudential regulation
• Banks play a central role in the economy, but are inherently unstable
• Excessive risk in lending and runs on the liability side
• Bank failures can become systemic and cause large declines in economic activity
• Prudential regulation aims at preserving financial stability
• Ultimate goal: support lending and economic growth
• Main regulatory tools
• Micro-prudential: capital regulation, liquidity regulation, licensing
• Macro-prudential: capital buffers, borrower-based measures, etc.
How does competition affect financial stability?
Competition-fragility view
• Charter-value hypothesis: Lower margins increase bank risk taking (Keeley, 2000)
• Higher deposit rates may exacerbate runs (Matutes and Vives 1996, 2000)
Competition-stability view
• Lower loan rates improve borrower and bank portfolio risk (Boyd and De Nicoló, 2005)
• Large banks become “too big to fail” and take excessive risk (Mishkin 1999)
How does competition affect financial stability?
Competition-fragility view
• Charter-value hypothesis: Lower margins increase bank risk taking (Keeley, 2000)
• Higher deposit rates may exacerbate runs (Matutes and Vives 1996, 2000)
Competition-stability view
• Lower loan rates improve borrower and bank portfolio risk (Boyd and De Nicoló, 2005)
• Large banks become “too big to fail” and take excessive risk (Mishkin 1999)
Empirical evidence is mixed:
1. More concentration leads to more/less risk depending on sample, time, measure, etc.
2. Overall competition can be beneficial if “not excessive” (i.e., U-shaped benefit)
Caveat 1: How to measure competition empirically?
• Structural measures (structure-conduct-performance paradigm)
• Concentration ratios, number of banks, Herfindahl-Hirschman index (HHI)
• Direct measures (conduct/behavior approach, even irrespective of market structure)
• Lerner index – measures market power by comparing price vs. marginal cost
• Panzar-Rosse H-statistic – uses revenue elasticity to input prices
• Boone indicator (relative profit differences) – checks if more efficient banks gain more market share
• Market contestability
• Presence of foreign ownership
• Formal/informal entry barriers, including those imposed by regulation
Caveat 1: How to measure competition empirically?
• Structural measures (structure-conduct-performance paradigm)
• Concentration ratios, number of banks, Herfindahl-Hirschman index (HHI)
• Direct measures (conduct/behavior approach, even irrespective of market structure)
• Lerner index – measures market power by comparing price vs. marginal cost
• Panzar-Rosse H-statistic – uses revenue elasticity to input prices
• Boone indicator (relative profit differences) – checks if more efficient banks gain more market share
• Market contestability
Best measure for effective competition
• Presence of foreign ownership
• Formal/informal entry barriers, including those imposed by regulation Not appropriate Better but difficult to implement
Caveat 1: How to measure competition empirically?
• Structural measures (structure-conduct-performance paradigm)
• Concentration ratios, number of banks, Herfindahl-Hirschman index (HHI)
• Direct measures (conduct/behavior approach, even irrespective of market structure)
• Lerner index – measures market power by comparing price vs. marginal cost
• Panzar-Rosse H-statistic – uses revenue elasticity to input prices
• Boone indicator (relative profit differences) – checks if more efficient banks gain more market share
• Market contestability
• Presence of foreign ownership
• Formal/informal entry barriers, including those imposed by regulation Not appropriate Better but difficult to implement Best measure for effective competition
Caveat 2:
• Banks are multi-product firms operating in multiple markets
• Competition is defined relative to a specific product and geographical market but boundaries are blurring (e.g., digital banking)
1. Prudential regulation can shape market structure
− Licensing and capital requirements raise barriers to entry
2. Public support and TBTF distort competition
• Entrenchment of too-big-to-fail institutions, potentially slowing down innovation
• Higher impediments to exit
1. Prudential regulation can shape market structure
− Licensing and capital requirements raise barriers to entry
2. Public support and TBTF distort competition
• Entrenchment of too-big-to-fail institutions, potentially slowing down innovation
• Higher impediments to exit
How to improve? 1. Adequate proportionality to smaller entities and potential entrants 2. Robust resolution regimes to facilitate orderly exit and ameliorate TBTF problem
3. Apply competition considerations in prudential regulation
Competition and stability in practice: merger control
• In practice financial stability and competition are not always given the same weight
• Substantial heterogeneity in the design of merger control across countries
− PA and CA may share responsibility
− PA may override CA for reasons of public interest or stability
− A third party may have the final say
• Examples where competition has been subordinated to prudential concerns
− Lloyds - HBOS in UK
− UBS - Credit Suisse in Switzerland
Conclusions
• Banks should not be excluded from competitive assessments
− Crucial to foster innovation and efficiency
• But banking competition is different from the one of other sectors
− Important to put discussion in the context of modern banking (e.g., digital banking), so far focus mostly on retail banking and traditional lending
Conclusions
• Banks should not be excluded from competitive assessments
− Crucial to foster innovation and efficiency
• But banking competition is different from the one of other sectors
− Important to put discussion in the context of modern banking (e.g., digital banking), so far focus mostly on retail banking and traditional lending
• A final word of caution
• New deregulation wave in various jurisdictions (US, UK, NZ, etc.)
• Financial crises are (strongly) linked to regulatory cycles
• Need of being very careful, also from competition perspective