Last bank standing: What do I gain if you fail?
Banks are highly leveraged institutions, potentially attracted to speculative lending even without deposit insurance. A counterbalancing incentive to lend prudently is the risk of loss of charter value, which depends on future rents. We show in a dynamic model that current concentration does not reduce speculative lending, and may in fact increase it. In contrast, a policy of temporary increases in market concentration after a bank failure, by promoting a takeover of failed banks by a solvent institution, is very effective. By making speculative lending decisions strategic substitutes, it grants bankers an incentive to remain solvent. Subsequent entry policy fine-tunes the trade-off between the social costs of reduced competition and the gain in stability.
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