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.

Keywords: Bank competition, Bank failure, Credit risk, Default correlation, Franchise values, Loan defaults, Loan rates, Moral hazard, Net interest income, Risk-shifting

JEL Classification: D43, E43, G21