DP2933 Last Bank Standing: What Do I Gain if You Fail?

Author(s): Enrico C Perotti, Javier Suarez
Publication Date: August 2001
Keyword(s): bank mergers, banking crises, charter value, market structure dynamics, prudential regulation
JEL(s): G21, G28, L10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2933

Banks are highly leveraged institutions, potentially attracted to speculative lending even without deposit insurance. A counterbalancing incentive to lend prudently is the risk of loss of charter value, which depends on future rents. We show in a dynamic model that current concentration does not reduce speculative lending, and may in fact increase it. In contrast, a policy of temporary increases in market concentration after a bank failure, by promoting a takeover of failed banks by a solvent institution, is very effective. By making speculative lending decisions strategic substitutes, it grants bankers an incentive to remain solvent. Subsequent entry policy fine-tunes the trade-off between the social costs of reduced competition and the gain in stability.