How Does Competition Impact Bank Risk Taking?
Jesus Saurina Salas
Bank of Spain
Banco de España
Jose A. Lopez
Federal Reserve Bank of San Francisco
EFA 2007 Ljubljana Meetings Paper
FRB of San Francisco Working Paper No. 2007-23
AFA 2008 New Orleans Meetings Paper
A common assumption in the academic literature and in the actual supervision of banking systems worldwide is that franchise value plays a key role in limiting bank risk-taking. As the underlying source of franchise value is assumed to be market power, reduced competition has been considered to promote banking stability. Boyd and De Nicolo (2005) propose an alternative view where concentration in the loan market could lead to increased borrower debt loads and a corresponding increase in loan defaults that undermine bank stability. Martinez-Miera and Repullo (2007) encompass both approaches by proposing a nonlinear relationship between competition and bank risk-taking. Using unique datasets for the Spanish banking system, we examine the empirical nature of that relationship. After controlling for macroeconomic conditions and bank characteristics, we find that standard measures of market concentration do not affect the ratio of non-performing commercial loans (NPL), our measure of bank risk. However, using Lerner indexes based on bank-specific interest rates, we find a negative relationship between loan market power and bank risk. This result provides evidence in favor of the franchise value paradigm.
Number of Pages in PDF File: 37
Keywords: bank competition, franchise value, Lerner index
JEL Classification: G21, L11
Date posted: February 27, 2007