Bank Competition and Financial Stability in India: Testing the Competition-Stability vs. Competition-Fragility Hypothesis

Abstract

This study empirically examines the relationship between bank competition and financial stability for the Indian banking sector using a dynamic panel dataset of 75 scheduled commercial banks over 2000–2021. We employ the Lerner index as a bank-specific measure of market power and the Z-score as a proxy for financial stability. Comprehensive diagnostic checks—including Wooldridge autocorrelation, Variance Inflation Factor (VIF), modified Wald heteroskedasticity, Pearsan cross-sectional dependence, and Ramsey RESET specification tests— confirm the validity of our econometric approach. Baseline fixed-effects regressions and system GMM estimations robustly support the competition-fragility hypothesis: greater bank market power is associated with significantly higher financial stability. A statistically significant U-shaped non-linearity is identified, but its turning point (Lerner ≈ 0.08) lies well below the sample mean (0.23), rendering the relationship effectively monotonically positive across the Indian banking system. Ownership-disaggregated analysis reveals that the effect is strongest for public sector banks, moderate for private sector banks, and statistically insignificant for foreign banks. Our findings carry important policy implications: competition-enhancing reforms in India should be complemented by strengthened prudential regulation to prevent adverse stability effects.