Essays on Bank Spatial Competition, Stability and Resolution

Abstract

This thesis empirically examines bank spatial competition, stability, and resolution. It is comprised of three empirical studies that investigate risk-return dynamics from three different aspects within the rural banking setting of Indonesia from 2014 to 2018. The specific focus is on bank performance, regional finance, shadow prices of equity capital, and cost efficiency. The first chapter presents a new competition measure based on two spatial variables: physical distances and Thiessen polygon market boundaries. The results show that spatial competition significantly affects profitability. I also find bank efficiency is higher for shorter distances between banks and larger boundaries. Further evidence using the Lerner index suggests that banks exert some pricing power, which is consistent with the monopolistically competitive structure of the industry. The second chapter investigates spatial competition and bank stability, using a spatial autoregressive model (SAR) with spatial spillover (contagion) constructed by weight matrices based on the inverse distance between a bank and its neighbouring banks. The results show a positive relationship between bank stability and market power, which supports the competition-fragility hypothesis. These results are robust following the use of GMM and 2SLS estimation of the SAR model to overcome endogeneity issues. In conclusion, the evidence supports the hypothesis that rural bank stability depends on the level of the spatial lag and competition from neighbouring banks. The final essay explores bank resolution and the shadow price of bank equity capital. The novel result of the study is that the shadow cost of capital serves as an indicator of the recovery rate. This is based on the presumption that deterioration of the quality of the bank’s assets portfolio will raise the cost of capital, effectively raising its shadow price. I also find that more efficient banks are associated with higher recovery rates, and that higher capital adequacy ratios are associated with less risk-taking. Furthermore, I examine the role of the shadow price of deposits and bank efficiency on deposit insurance. I conduct principal components analysis (PCA) to combine four types of risks to calculate the risk-based deposit premium. The rate varies from 0.146 percent to 0.423 percent. Thus, the results suggest that the deposit premium charged by the Indonesia Deposit Insurance Corporation (IDIC) does not reflect the cost to the IDIC. I also find that banks exploit an implicit deposit insurance subsidy.