Financial Liberalization, Competition, and Bank Loan Quality

Abstract

The paper studies the relationship between financial liberalization, characterized by removing entry restrictions, and bank loan quality. It shows that if a banking market is liberalized, the opportunity cost of screening loan applicants is driven lower by competition. Thus, a bank facing an entry threat is more likely to invest in screening instead of relying on collateral requirements. Removing entry restrictions may improve loan quality stability and reduce correlation between bank performance and asset price fluctuations.

Banking deregulation and credit risk: Evidence from the EU

“…The theoretical results reinforce those of Chen (2005) and Chen and Haller (2003), but the models differ in the following aspects. Chen (2005) 4 considers banks' choice between two prudent measures: screening of loan borrowers and collateral requirements, with the latter being more vulnerable to asset price shocks.…”

“…The simple model has a basic set-up similar to those in Chen (2005), Chen and Haller (2003), and Gehrig (1998), except for the differences discussed in the introduction. Consider a credit market where banks face two types of firms, with the total measure normalized to one.…”

“…In contrast, Chen and Haller (2003) argue that loan screening helps alleviate competitive pressure, and thus intenser competition can stimulate screening activities. Likewise, Chen (2005) considers a bank's choice between loan screening and collateral requirements, and concludes that it is more likely to choose the former rather than rely on the latter when facing competitive pressure from a potential entrant.…”

“…Further, this setting allows a better focus on the impact of credit risk (without consideration of market risk) on bank soundness. In addition, Chen (2005) assumes perfect screening technology, whereas imperfect screening technology is considered here, allowing differentiated intensity of screening effort. In Chen and Haller (2003), banks compete symmetrically, while an asymmetric case is considered in this paper, that is, the incumbent bank is considered to have an information advantage and therefore is assumed to have the technology for screening borrowers.…”

“…Chen (2005) 4 considers banks' choice between two prudent measures: screening of loan borrowers and collateral requirements, with the latter being more vulnerable to asset price shocks. By assuming away collateral requirements, this paper presents a simpler model that applies to a more general case in which banks issue non-collateralized loans.…”