circumstances, they may need to be complemented by interest rate ceilings or entry restrictions (Matutes and Vives, 2000).
Although the view of a detrimental relationship between competition and stability remains pervasive, some recent studies have suggested that such a relationship needs not be robust, For example, when entrepreneurs –and not banks- choose the risk of the investment project, greater competition in the loan market reduces entrepreneurs’ incentives to take risks, thus implying also safer portfolios for banks (Boyd and De Nicoló, 2005; and also Caminal and Matutes, 2002). If competition has an ambiguous effect on stability, the role of regulation needs rethinking. Boot and Marinc (2007) analyze the impact of capital regulation on entry and bank monitoring. The main insight of the analysis is that when banks are heterogeneous in quality and compete for market share, increasing capital requirements leads to more entry into banking. Competition improves the monitoring incentives of better quality banks and deteriorates the incentives for lower quality banks.
All in all it seems plausible to expect that, once a certain threshold is reached, an increase in the level of competition will tend to increase risk-taking incentives and the probability of bank failure. This tendency may be contained by reputational concerns, by the presence of private costs of failure of managers or by regulation. Constraining regulation may be particularly important for institutions that have run into trouble, their margins being severely eroded, and develop an incentive to use “gambling for resurrection” strategies. In any case the question remains open as to what degree of market power should be allowed in banking. Competition policy should be enforced in banking as the exercise of market power may be very important in the sector – despite electronic banking. The question is whether the application of competition policy should be modulated because of the stability concern.
5. Competition policy in the banking sector in the European Union We now turn to the institutional design of competition policy for the banking sector. Before the liberalization process the status quo was far away from the optimal balance