The Effect of Spatial Competition on Rural Banks Stability : Contagion Effect

This paper examines the effect of competition on bank stability particularly the contagion effect in rural banking market using spatial panel econometrics methodology. We obtain quarterly data from 2014 to 2017 focusing in a single country, Indonesia, as it has the largest number of rural banks in Asia and divides the analysis into 33 provinces. The efficiency-adjusted Lerner index is used to measure the market power of the banks and this index shows that banks have a mark-up price. In terms of control variables, we use bank-specific characteristics to proxy size, capital, and liquidity. Provincial macroeconomic indicators such as the growth of GDP, inflation and foreign exchange rate are also used in the present study. We construct the spatial variables as inverse distance and area of rural bank market per provinces. The contagion effect is measured by the indirect effect of two different channels: geographical spillover and rural banks zone based on FSA. The results reveal that there is a negative relationship between bank stability and market power which supports the competition-fragility hypothesis. The contagion effect does exist in a market that has the same zone categories (local area). In conclusion, we argue that the rural bank stability depends on the level of spatial competition