How does Competition Impact Bank Risk Taking

ABSTRACT: In the academic literature and in the actual supervision of banking systems worldwide, franchise value plays a key role in limiting the riskiness of individual banks and banking systems. The underlying source of franchise value is typically assumed to be market power, and hence reduced competition or, equivalently, market concentration has been considered to promote banking stability. In recent work, Boyd and De Nicoló (2005) propose an alternative view that market concentration could impact bank stability in different ways. Specifically, concentration in the loan market could lead to increased lending rates that both raise borrowers ’ debt loads and default probabilities as well as their incentive to engage in riskier projects. Using unique datasets for the Spanish banking system, we test for this “risk shifting ” paradigm. Our dependent variable is a bank’s ratio of non-performing commercial loans. After controlling for macroeconomic conditions and bank characteristics, we find that standard concentration measures do not affect bank NPL ratios. Using Lerner indexes based on bank-specific interest rates on loan and deposit products, we find a negative relationship between loan market power and bank risk; that is, as market power increases, bank NPL ratios decrease. This result is direct evidence in favor of the franchise value paradigm