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Competition and the risk of bank failure : Breaking with the representative borrower assumption

Abstract : We examine the relation between intensity of competition in the loan market and risk of bank failure, in a model with adverse selection. As well established, the presence of the two opposite margin and risk-shifting effects creates conditions for nonmonotonicity: the conventional competition-fragility view may be challenged at high interest rates. These rates may however be too high to be compatible with oligopolistic equilibrium conditions. The challenging competition-stability view has been argued in terms of a representative borrower managing the profitability-safeness trade-off under moral hazard. However, the representative borrower assumption is not innocuous, playing down by construction the margin effect. The paper considers the adverse selection situation where that trade-off is managed by banks facing heterogeneous borrowers, and shows analytically, in the case of a trapezoidal distribution of idiosyncratic and systemic risk factors, that the conventional view is always valid.
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https://hal.univ-lorraine.fr/hal-03595060
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Submitted on : Thursday, March 3, 2022 - 10:03:52 AM
Last modification on : Saturday, April 16, 2022 - 3:36:41 AM

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Distributed under a Creative Commons Attribution - NonCommercial - NoDerivatives 4.0 International License

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Rodolphe dos Santos Ferreira, Leonor Modesto. Competition and the risk of bank failure : Breaking with the representative borrower assumption. Journal of Public Economic Theory, Wiley, 2021, 23 (4), pp.622-638. ⟨10.1111/jpet.12509⟩. ⟨hal-03595060⟩

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