Does Competition Reduce the Risk of Bank Failure?

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.

Bank Competition and Financial (In)Stability in Europe: A Sensitivity Analysis

“…Martinez-Miera and Repullo (2010) concur that there exists a U-shaped relationship between competition and bank failure risk. In particular, monopolistic markets experience the risk-shifting effect, that is more competition with low loan rates stabilizes banks as they run less risk of default whereas the margin effect -lower revenues of total nondefaulting loans may jeopardize banks in view of potential entries -occurs usually in competitive markets.…”

Bank Competition and Financial Stability: A General Equilibrium Exposition

“…In this more complex setting, the risk-shifting argument is applied to two entities, firms and banks, rather than one. Recent extensions of this type of model, including bank heterogeneity (De Nicolò and Loukoianova, 2007), the introduction of different assets (Boyd, De Nicolò and Jalal, 2009), or a different risk structure (Martinez-Miera and Repullo, 2010), have all aimed at establishing under what conditions the presence of two risk-shifting effects generates a tradeoff between bank competition and financial stability.…”

Foreign Competition and Banking Industry Dynamics: An Application to Mexico

“…Another external shock, the Mexican "tequila crisis" in 1994 resulted in a large increase in non-performing loans. Bank insolvency associated with this episode was estimated by Maudos and Solis [20] to cost Mexican taxpayers 19.3% of GDP. At that time, the Mexican government gradually removed restrictions on foreign participation.…”

“…3 Like Martinez-Miera and Repullo [19], we allow shocks to borrower solvency to be correlated across agents unlike Boyd and De Nicolo [7]. In particular, borrower solvency is correlated with the business cycle.…”

“…As Martinez-Miera and Repullo [19] the parameter α captures the correlation of solvency across borrowers. Further, we let the distribution of the entrepreneur's outside option Υ(ω) to be a uniform distribution with support defined by [ω, ω].…”