Competition and Bank Systemic Risk: New Evidence from Japan's Regional Banking

Bank competition and financial stability is a recurrent research issue, and researchers have begun to shed light on the competition effect on systemic-risk. Japan is an interesting case in this venue since its regional banking system has confronted intensified competition and there is growing evidence that the competition has led the portfolio of Japan's regional banks to be more overlapped, an indication of increased systemic risk. In this paper, we first examine the empirical relationship between competition and systemic-risk for Japan's regional banks. We find that the bank mark-up is negatively associated with the level of systemic risk, indicating that competition undermines the system-wide financial stability in Japan. However, this result is at odds with existing studies. To this end, we perform a theoretical analysis focusing on bank's portfolio diversification. We demonstrate that Japan's regional banks tend to diversify toward alternative lending when the profitability of the core business declines. This diversification results in the build-up of systemic risk through higher common exposure, a form of indirect interconnectedness.