On the relationship between bank market concentration and stability of financial institutions: Evidence from the Italian banking sector

This paper explores the relationship between bank market concentration and financial stability of financial institutions relying on highly territorially disaggregated data taken at municipality level in Italy between 2001 and 2012. Firstly, we test the existence of a U-shaped relationship between market concentration and financial stability. Secondly, we estimate the impact of the level of concentration of the banking system and other explanatory variables, such as size, level of capitalization and credit insolvency of financial institutions, on a proxy of risk taking behavior such as the banking ‘‘stability inefficiency’’ derived simultaneously from the estimation of a stability stochastic frontier. The paper concludes that the inefficiency of financial stability is U-shaped relationship with respect to the measure of market concentration. Boosting market power increases bank failure in very concentrated markets while leads to higher financial stability in already competitive markets. Bank size is an essential factor in explaining this relationship as the effect of size on the inefficiency of stability is an inverse U-shaped as a function of the market share indicator; results also suggest that high, low and average concentration levels do not change the positive effects that the level of capitalization has on the stability inefficiency.