Working Paper: CEPR ID: DP6669
Authors: David Martinez-Miera; Rafael Repullo
Abstract: A large theoretical literature shows that competition reduces banks' franchise values and induces them to take more risk. Recent research contradicts this result: When banks charge lower rates, their borrowers have an incentive to choose safer investments, so they will in turn be safer. However, this argument does not take into account the fact that lower rates also reduce the banks' revenues from non-defaulting loans. This paper shows that when this effect is taken into account, a U-shaped relationship between competition and the risk of bank failure generally obtains.
Keywords: bank competition; bank failure; credit risk; default correlation; franchise values; loan defaults; loan rates; moral hazard; net interest income; risk-shifting
JEL Codes: D43; E43; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased competition in banking (G21) | Lower loan rates (G21) |
| Lower loan rates (G21) | Higher probability of loan defaults (G21) |
| Increased competition in banking (G21) | Higher probability of loan defaults (G21) |
| Perfect correlation of loan defaults (G33) | Higher probability of loan defaults (G21) |
| Imperfect correlation of loan defaults (G33) | Margin effect that counteracts risk-shifting effect (D81) |
| Increased number of banks (G21) | Initially reduces risk of bank failure (G21) |
| Beyond a certain point (Y60) | Increases risk of bank failure (F65) |
| Moderate competition (L13) | Minimizes risk of bank failure (G21) |
| Excessive competition and monopoly conditions (L12) | Increase risk of bank failure (F65) |