Balancing prudential regulation and competition considerations in banking

Executive summary

Sound retail banking markets drive productivity and growth, and prudential regulation ensures resilience and stability by mitigating systemic vulnerabilities and maintaining trust in the banking system. Well-functioning retail banking markets are critical to supporting economic productivity, long-term growth, economic resilience and financial stability.1 Banks hold a significant share of household wealth and create commercial money by extending vital credit to households and businesses.2 Yet these same functions generate vulnerabilities, such as liquidity mismatches, interbank linkages and information asymmetries.3 Prudential regulation governs financial activities and imposes licensing requirements and minimum capital standards to mitigate these vulnerabilities and maintain depositor confidence. By screening entrants and ensuring that banks hold sufficient buffers to absorb losses, it aims to reduce the likelihood of institutional failure, limit systemic contagion and safeguard the financial system.

Competition in banking, in turn, is a key driver of efficiency, innovation and improved consumer outcomes. Dynamic, contestable markets lower borrowing costs, improve deposit conditions, and expand both the quality and diversity of financial services. By ensuring that entry remains feasible and exit credible, contestability keeps pressure on incumbents, disciplines market power, and channels resources toward productivity and improved consumer outcomes. Competition can also reinforce resilience by fostering higher-quality institutions, which, alongside effective prudential oversight, can help to curb excessive risk-taking.

Nevertheless, there are some inherent tensions between prudential and competition policy goals. Where contestability relies on the possibility of entry and exit, prudential regulation seeks to prevent disorderly exits that may trigger runs or contagion.4 Prudential tools to safeguard stability may, at times, inadvertently raise barriers to entry and expansion, entrench incumbents or slow innovation. Conversely, limited prudential supervision of new entrants, such as non-bank financial intermediaries (NBFIs), including FinTechs and BigTechs, which are increasingly performing bank-like functions, may pose prudential risks.5

Effective prudential regulation, like other public policies, benefits from balancing trade-offs across different time horizons, including effects on competition. All prudential rules shape market dynamics, for example, by limiting entry into certain financial activities or setting capital requirements. Prudential safeguards can be designed to take competition into account. This may involve ensuring that rules minimise bottlenecks to competition, are competition-neutral, or facilitate competition. Balancing competition and prudential goals takes on greater significance amid opportunities arising from digitisation and new entry, as well as the emerging risks they pose, including through bank-NBFI interdependencies. Trends toward consolidation in retail deposits and lending services may heighten tensions over policy remits and give rise to shared concerns about market power and potential systemic risks.6 While regulatory frameworks differ across countries, as do market structures and the role of NBFIs, the challenge of reconciling prudential and competition goals is widely shared.

Policymakers, prudential regulators and competition authorities have an essential role to play in managing trade-offs and supporting the sector’s adjustment to challenges. Prudential regulation and competition policy can be complementary and, at times, reinforce one another. Through effective co‑operation and a balanced pursuit of their respective objectives, banking markets can become more resilient, efficient and innovative, delivering lasting benefits for consumers and the wider economy. To inform this balancing, this paper examines core banking services (retail deposits and lending) by both banks and NBFIs. It builds on prior OECD work, including discussions on prudential regulation and competition in financial markets (2009[1]), bank competition and financial stability (2011[2]), and co‑operation between competition agencies and regulators in the financial sector (2017[3]).

The paper highlights several considerations regarding the interaction between prudential regulation and competition policy:

• Prudential and competition objectives can interact in complex ways. The two policy areas are sometimes complementary, but at other times may pull in different directions. Understanding and managing these dynamics can be important to avoid long-term distortions in core banking markets.

• Digitisation and new entry broaden both opportunities and risks. The growing participation of FinTechs, BigTechs and other NBFIs introduces new forms of competition and innovation, but also new challenges and interdependencies relevant to both policy remits.

• Prudential rules inevitably shape market structure and competition. Licensing and capital requirements play a central role in safeguarding stability, but if not well-calibrated, they may unnecessarily limit entry, expansion, or exit and reinforce incumbency.

• Credible exit frameworks can mitigate risks. Mechanisms that allow inefficient financial institutions to exit the market in an orderly way can mitigate systemic risk and reduce long-term distortions to competition.

• Proportionate, risk-based frameworks may help reconcile objectives. Calibrating prudential requirements proportionally to size, complexity or risk profiles can preserve contestability while maintaining stability.

• Competition policy and enforcement can support prudential outcomes. By preventing exclusionary or co-ordinated practices and anticompetitive mergers, competition enforcement can contribute to more resilient and efficient markets.

• Effective regulatory co-operation enhances policy coherence. Regular dialogue and co-ordination between prudential and competition authorities can help ensure that measures designed to protect stability also sustain, or do not unnecessarily limit, the benefits of competition.

Notes

← 1.  There is no single global definition of “banking”. In most jurisdictions, however, banks are understood as institutions that take deposits, extend loans, or do both (Ehrentraud et al., 2024[53]). For this paper, which focuses on retail deposits and lending, the term' banking sector' (or 'banking markets') encompasses services provided by traditional banks, digital banks (also known as neobanks) and non-bank financial intermediaries (NBFIs). Unless otherwise noted, “banks” refers to both traditional and digital banks (Ehrentraud, Garcia and Quevedo, 2020[57]).

← 2.  Commercial money refers to money created by banks through their lending activities. Unlike central bank money, commercial money is not legal tender but is widely used in transactions and accounts for a significant portion of currency in circulation.

← 3.  Liquidity mismatches occur when the maturity of assets and liabilities do not align, leading to potential solvency problems. Key causes include duration mismatches, where financial institutions invest in long-term assets while relying on short-term funding sources, and behavioural mismatches, such as market panics that cause sudden withdrawals (Carletti and Hartmann, 2002[5]; OECD, 2011[2]). Interbank linkages may occur, for example, through interbank lending. This allows banks to share credit risk, but it also enables one bank's crisis to potentially spread across the whole network (Grilli, Tedeschi and Gallegati, 2014[130]). Informational asymmetries are a defining characteristic of banking markets. For example, when offering credit to borrowers, lending institutions face uncertainty about their creditworthiness. These informational asymmetries may lead to credit rationing and may deviate from the standard results of competitive markets (Dell’Ariccia, 2001[89]).

← 4.  Runs occur when a large number of customers withdraw their deposits simultaneously due to fears that the financial institutions, where these deposits are held, may become insolvent. Contagion refers to the spread of an economic crisis from one institution or market to another, occurring at both domestic and international levels.

← 5.  Non-bank financial intermediaries (NBFIs) are also known as non-bank financial companies (NBFCs).

← 6.  Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Certain financial institutions may be deemed systemically important or too big to fail (TBTF) if their failure would cause unacceptable disruptions to the overall financial system. They may be TBTF because of their size or interconnectedness (Labonte, 2018[131]).