Financial Stability in a Moderately Competitive Banking Market: Evidence from the Sri Lankan Banking Sector

Abstract

Banks in the developing countries are competing in an environment where the financial infrastructure or the prerequisites for such competition is lacking. Therefore there is a current debate in banking literature regarding the effect of bank competition on the stability of the banking sector. The present paper provides new and rather scarce evidence of effects of banking sector competition on financial stability of the Sri Lankan banking sector during the period 1996 to 2010. By analyzing a comprehensive set of panel data the study reveals that the Sri Lankan banking sector is moderately competitive as per Panzar and Rosse H-Statistic and, highly unstable as per Z- score. The results of the core analysis provide evidence for a U shape relationship between competition and stability in the Sri Lankan banking sector during the sample period. Hence, a different approach emerges, with underdeveloped countries giving a stronger role to competition authorities to understanding the complex relationship between competition and stability in the financial sector.