Prudential regulation, stabilization and bank competition: Short and long run evidence from Asia

Abstract
We study how changes in prudential regulation affect bank competition in two distinct markets: traditional intermediation and fee-based services. Using bank-level data for eight Asian economies for the period 2001–2018, we estimate short-run and long-run competition separately, along with their determinants. We find that banks adjust quickly to regulatory changes in the short run, but that frequent policy changes are costly in the long run: regulatory variability is associated with persistently weaker competition, especially in fee-based activities. Policy instruments also have market-specific effects: stricter capital requirements mainly reduce competition in fee-based services, while stronger supervisory powers mainly reduce competition in lending. The results suggest that prudential frameworks should assess competition across multiple banking markets and avoid unnecessary policy churn.

Introduction

Prudential and supervisory regulatory reforms are often introduced to strengthen resilience and reduce systemic risk, especially in the aftermath of financial crises. Yet competition is a key part of the transmission from regulation to welfare: it influences credit availability and pricing, incentives to innovate, and the pace at which new entrants and new business models develop. Despite its relevance, the impact of regulation on competition has been largely neglected by academic literature, as interest has focused mainly on its stability implications (Berger and Boot, 2024). A further limitation of extant literature is that it often ignores the multimarket nature of bank production. Alongside the traditional intermediation business (deposit-taking and lending), banks have long expanded into fee-based services such as payments, wealth management, and other non-interest activities. Ignoring this multi-market structure can lead to bias in empirical analyses, and to inaccurate or incomplete policy assessments: reforms that restrict or raise costs in one market may redirect competitive pressures to the other (Shaffer and Spierdijk, 2020).

In this work1 we address the above limitations and look at the effect that prudential regulation has on bank competition in separate markets and over different time horizons. Our focus is on the regulatory experience of eight Asian banking systems (China, Hong Kong, India, Indonesia, Japan, Malaysia, the Philippines and Thailand) between 2001 and 2018. The period captures the prudential reforms that followed the Asian Financial Crisis (AFC) and stops with the structural break of the Covid pandemic. The reforms were stability-focused and helped shield the region from the Great Financial Crisis (GFC); competition concerns were not part of the main narrative. While data limitations prevented us from enlarging the analysis to other countries in the region, our sample choice has the advantage of exploiting meaningful cross country variation in development and institutions, while avoiding the extreme heterogeneity of larger global panels and the associated omitted variable risks. Furthermore, since post-AFC key measures were implemented with an explicit stabilization mandate, reverse causality concerns, whereby regulation simply responds to contemporaneous shifts in competition, are mitigated (Kim et al., 2019). Fig 1 shows the aggregate yearly levels of regulatory stringency and economic freedom of the eight countries over the period of observation.

Methodologically we build on recent advances in competition measurement and stochastic frontier methods. Specifically, we adopt the competition-efficiency framework of Bolt and Humphrey (2010, 2015a,b) and extend it to a flexible four component specification (Colombi et al., 2014), which enables us to distinguish short run from long run effects and to model their determinants explicitly: we look at four continuous indices of regulatory stringency from Barth et al. (2001, 2003, 2007, 2013, 2018) – activities restrictions, capital stringency, supervisory powers, and market discipline – and an index of general economic freedom (obtained from the Fraser Institute), along with measures of market structure, bank ownership and an index of output diversification.

In essence, Bolt and Humphrey’s model infers competition indirectly from the composite residual of a net unit revenue equation, after controlling for productivity, risk and other drivers. The composite nature of the error term is what makes it a frontier model, with competition measured as the inefficiency component. This helps avoid the interpretational ambiguity that can arise with mark up measures (e.g., the Lerner index), where price – cost gaps may reflect efficiency or risk differences rather than competitive pressure. A further advantage is that the approach can be implemented separately by output market without being constrained by detailed price or cost data requirements. Finally, our methodological choice of a four component stochastic frontier allows us to separate not only noise from unobserved bank heterogeneity, but also persistent (long run) versus transient (short run) competition, along with their determinants.

Figure. 1. Levels of regulatory stringency (reg) and economic freedom (ecfr) in Asian countries 2001-2018

Main empirical findings

Competition is lower and more persistent in fee-based services.
Across countries, we find that competition is typically higher in lending than in fee-based activities. Short-run (transient) competition is relatively high in both markets, but the long-run (persistent) component is notably weaker for fee-based services (see Fig. 2). This is consistent with the idea that banks diversify towards fee income partly because margins are higher and competition is initially lower. Over time, as participation broadens, competition in fee-based services tends to improve, but it remains structurally lower than in lending.

Figure 2. Average short and long run competition in lending and fee-based services

Regulatory variability matters: “policy churn” is costly

A central finding is that long-run competition responds negatively to regulatory variability. Put simply, banks can adjust operationally to new requirements, but a high frequency of changes (or frequent shifts in the overall stance) increases uncertainty, raises compliance and adjustment costs, and is associated with lower competition over longer horizons. This long-run effect is present in both markets and is stronger for fee-based activities.

Different regulatory tools affect markets differently

We find that in the short run policy tools have directionally similar effects in some, but not all, markets. Fig. 3 shows the relative size and direction of the impact of the main determinants.

• Activities restrictions: stricter restrictions are associated with stronger competitive effort, especially in fees and commissions. This can result from an increase in market contestability, if restrictions affect the volume and not just the type of activities that banks can perform; or from a reduction in moral hazard and risk-taking behavior resulting from a less broad financial spectrum, which could lead to higher productive efficiency.
• Market discipline and transparency: greater transparency and disclosure are associated with higher competition, as they reduce informational asymmetry. This is true for both markets both in size and significance.
• Capital requirements: more stringent capital requirements are associated with significantly weaker competition in fee-based services. Although these requirements are calibrated mainly with lending risk in mind, they operate at the level of the whole bank. They raise the overall cost of funding, compliance and internal capital allocation, leaving less room to price aggressively or expand in adjacent fee-based businesses. This matters because, unlike lending, on this market banks compete also with other financial intermediaries that are not affected by the same capital requirements. The result is a relative competitive disadvantage for banks in fee-based markets.
• Supervisory powers: stronger supervisory powers, which are conceived mainly as a safety and stability tool, often correlate with lower credit risk. Consistently with this we find that they reduce competition mainly in lending.

Figure 3. Relative size and direction of the main determinants of competition

Market structure and business models still matter

• Our results on the impact of different ownership structures support what is known in the literature as the home field advantage (Berger et al, 2000): foreign banks are less competitive than domestic, and especially state, ones (see Fig. 4); they compete only with each other and probably cherry pick. This is probably a reflection of the region’s very low presence of foreign banks (with the exception of Hong Kong) and of the still relative dominance of state banks.
• Higher concentration tends to reduce competition in lending. In fee-based activities, the relationship can differ, plausibly because larger banks are more active in these markets and compete more directly for market share. Finally, diversification is associated with stronger competition.

Figure 4. Competitiveness of state and foreign banks relative to domestic private banks

Conclusion

Three main messages emerge from our analysis. First, banks tend to adjust quickly to regulatory change: short run competitive conditions respond promptly and are generally stronger in intermediation than in fee based services. Second, policy volatility matters: frequent or wide ranging regulatory changes are associated with weaker long run competitiveness, with particularly pronounced effects in the newer fee based segment. Third, determinants of competition are market specific. Diversification and broader participation support competition over time; transparency and economic freedom are consistently pro competitive. However, the effects of individual prudential tools diverge: tighter capital requirements curb competition mainly in fee based activities, where banks face competition from non bank providers, while stronger supervisory powers primarily operate through the lending market by shaping credit risk and intermediation discipline. Concentration continues to be associated with weaker competition in lending, and limited foreign bank presence may facilitate selective entry strategies. These findings have clear policy implications. Prudential impact assessments should not focus only on resilience, solvency and credit supply, but also on how reforms reshape competition across banks’ different business lines. A measure that is neutral or desirable from a stability perspective in lending may still weaken banks’ ability to compete in fee-based markets, particularly where non-bank providers face lighter prudential burdens. This argues for a more explicitly multi-market approach to prudential design, together with greater attention to regulatory consistency and predictability over time.