Balancing Competition and Stability: A Modern Regulatory Framework for Finance

Pietro Calice’s latest contribution, published by the World Bank’s Finance, Competitiveness and Investment Global Department, revisits a foundational economic policy principle, the Tinbergen rule, with fresh eyes and bold ambition. Originally conceived by Jan Tinbergen at the Netherlands School of Economics in the 1950s, the rule asserts that for every independent policy target, there must be a corresponding independent policy instrument. While this idea has long shaped macroeconomic thought, Calice argues that such linear thinking falls short in today’s complex financial systems. Drawing insights from institutions like the Basel Committee on Banking Supervision (BCBS), the International Monetary Fund (IMF), and the Financial Stability Institute (FSI), he proposes a dynamic reconfiguration that better captures the tangled relationship between market competition and financial stability.

Competition and Stability: Friends, Foes, or Both?

At the heart of the paper lies the claim that competition and financial stability do not exist in isolation but interact in complex, non-linear ways. Calice points to a well-documented inverted U-shaped relationship between these two forces. In systems with very low competition, banks often gain monopolistic power, allowing them to charge high loan rates, which may push borrowers toward riskier behaviors, known as the “risk-shifting” hypothesis. At the other extreme, excessive competition can erode profit margins and franchise value, encouraging financial institutions to take on greater risks to survive, a dynamic captured by the “franchise value” hypothesis. Somewhere in between lies the sweet spot: a level of moderate competition that supports both efficiency and systemic resilience.

This nuanced relationship poses a serious challenge to the classical Tinbergen rule. When competition and stability interact so intimately, assigning distinct tools to each objective is no longer feasible. Instruments often affect both variables simultaneously, creating trade-offs that must be managed dynamically. For instance, stringent capital requirements designed to bolster stability can inadvertently restrict entry, thereby stifling competition.

Introducing the Regulatory Frontier

To address these challenges, Calice introduces the concept of the “Regulatory Frontier”, a conceptual space representing the feasible combinations of competition and stability outcomes. Shaped like an inverted U-curve, this frontier has an apex where competition (denoted as C*) maximizes financial stability. The policymaker’s job is to identify the financial system’s current position on this curve and select policies that move it closer to the optimal zone while respecting a baseline minimum level of acceptable stability (S_min).

Crucially, this approach transforms the Tinbergen rule from a static framework into a dynamic optimization process. In normal times, policymakers may pursue policies near the curve’s apex, but during times of financial stress, priorities shift toward reinforcing stability, even if it means temporarily reducing competition. The framework also includes a state-contingent welfare function, allowing regulators to adjust the weight given to stability versus competition depending on current conditions.

Mapping the Instruments: A New Taxonomy for Smart Regulation

One of the paper’s most practical contributions is its detailed taxonomy of regulatory tools. Instruments are no longer simply divided by purpose, such as competition tools or prudential measures, but are also assessed for their cross-effects. Stability instruments, for example, may be classified as competition-enhancing (e.g., robust bank resolution frameworks), competition-neutral (e.g., stress testing or disclosure requirements), or competition-constraining (e.g., high capital buffers or entry restrictions). Similarly, competition tools like entry liberalization or open banking may either promote, ignore, or undermine stability depending on context.

The paper also identifies a third class of instruments, calibration tools, that help fine-tune the system dynamically. These include differentiated licensing regimes, risk-adjusted deposit insurance, and structured compensation rules that align incentives over the long term. Rather than a one-size-fits-all toolkit, regulators are encouraged to see these instruments as adjustable levers, whose intensity and configuration should evolve with the system’s needs.

From Theory to Practice: Real-World Applications

To illustrate this adaptive framework, Calice analyzes how different economies have navigated the competition-stability trade-off. Canada is highlighted as an example of a banking system operating near the optimal competition point, characterized by stability, contestable market conditions, and prudent supervision. Conversely, Kenya’s rapid proliferation of digital lenders created intense competition that eventually raised stability concerns. The government responded with tighter licensing requirements and enhanced oversight, effectively moving the system back toward a safer equilibrium.

Meanwhile, post-crisis reforms in the UK saw regulators encouraging new bank entries while simultaneously strengthening resolution regimes and capital standards. Australia and South Korea are also cited for deploying macroprudential tools such as loan-to-value caps and countercyclical capital buffers to mitigate risks from overheating credit markets without choking off healthy competition.

Building Institutions for Dynamic Regulation

The success of this framework depends heavily on the quality of institutional arrangements. Calice discusses two prevailing models: one where competition and prudential oversight are housed in separate agencies requiring robust coordination mechanisms, and another where both mandates are integrated into a single supervisory body. In either case, formal protocols, such as joint decision-making committees, shared data systems, and conflict resolution procedures, are critical to harmonize policy objectives.

Calice’s work extends the Tinbergen rule into the 21st century, offering a dynamic, data-informed, and context-sensitive approach to financial regulation. It acknowledges the complex reality that competition and stability are deeply intertwined and provides regulators with a pragmatic roadmap for managing that relationship. As financial systems evolve through innovation and globalization, such a flexible and nuanced regulatory model may prove essential for maintaining resilient and inclusive financial markets.