Large Banks and Efficient Banks: how Do they Influence Credit Supply and Default Risk?

This study examines two questions relating to the banking market structure. First, does the banking market structure influence banks’ decisions to originate new single-family home mortgages? Second, does the banking market concentration affect mortgage default risks? Using a two-stage approach with the inputs from two data sources on the banking market in the US and mortgages in non-agency securitization pools for the period from 1999 to 2008, we find that banks operating in the markets with a low entry barrier (efficient banks) increase credit supply, while banks possessing market power restrict credit supply to the mortgage markets. Banks with market power originate loans that have lower default risk compared to loans originated by banks in the competitive markets. Efficient banks use mortgage technology indiscriminately to increase credit supply even at the expense of lowering credit quality (increasing default risks). We show that the effects of banking market structure are not correlated with legislation risks and population size in the markets.