The Impact of Market Power on Bank Risk-Taking: an Empirical Investigation

There has been a great deal of interest in investigating banks’ risk-taking incentives because of their relevant role in the stability of the financial system. Until now, we know relatively little about what gives rise to such risk-taking in the first place. In this paper, we seek to examine the impact of market power on risk-taking behavior of banks in 5 European countries between 2002 and 2015. Our main results suggest that greater competition leads to the instability of the financial system, since the measure of bank competition is significantly positively related to the Z score. In addition, we find that a stronger economic growth is associated with more stabilized bank asset returns, but this stabilizing force is stopped when market power is more pervasive in the economy. During the global financial crisis period, banks in less competitive markets exhibit higher bank credit risk. We also verify that after the implementation of Basel III, market power has a positive impact on bank risk-taking and in a stronger way in comparison with the pre-Basel III.