What drives financial stability? the nexus between market power and bank efficiency within the East African Community

ABSTRACT The paper examines the joint effect of market power and different types of bank efficiency on financial stability across 5 countries within the East African Community. Unlike existing studies which have employed efficiency in a broad way, it is decomposed into five different types, that is, technical, pure technical, scale, cost and revenue efficiency. Using a two-step system GMM on 149 banks with 1,805 observations over the period 2001–2018, empirical findings reveal that the joint effect of market power and bank efficiency is critical on financial stability and the effect varies with the specific type of efficiency being explored. Increased market power is observed to have a direct positive effect on bank stability. With respect to bank efficiency, cost and revenue efficiency have a positive significant effect with bank stability while the effect of technical, pure technical and scale efficiency is insignificant. In overall, concentrated banks with higher cost and revenue efficiency are more stable compared to the inefficient banks. The findings highlight that an eclectic policy to ensure a trade-off between bank concentration and competition should be ensured by the bank regulators.