Monday, August 22, 2016

Could competition always raise the risk of bank failure?

Rodolphe Dos Santos Ferreira ; Teresa Lloyd-Braga ; and Leonor Modesto ask Could competition always raise the risk of bank failure?

ABSTRACT: The debate between the 'competition-fragility' and 'competition-stability' views has been centered upon the risk of banks' loan portfolios. In this paper, we shift the focus of the debate from the riskiness of loan portfolios to the riskiness of operational costs net of the income of non-traditional banking activities, banks' default resulting from negative aggregate profits. We consider a simple model in which, due to purely idiosyncratic risks, portfolio diversification would eliminate the risk of banks' default if those net operational costs were negligible or were known with certainty. We show that more competition always raises the risk of bank default, non-monotonicity being excluded as an equilibrium outcome under free oligopolistic competition between profit maximizing banks. However, the same result obtains in fact under systemic risk, even under non-stochastic net operation costs, a situation which we explore in a slightly different model. We sh! ow further that, under liquidity shortness, a higher intensity of competition in the loan market can result in an increase of deposit rates, rather than a decrease of loan rates.

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