DP6669 Does Competition Reduce the Risk of Bank Failure?

Author(s): David Martinez-Miera, Rafael Repullo
Publication Date: January 2008
Keyword(s): Bank competition, Bank failure, Credit risk, Default correlation, Franchise values, Loan defaults, Loan rates, Moral hazard, Net interest income, Risk-shifting
JEL(s): D43, E43, G21
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6669

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.