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Competition and the risk of bank failure : Breaking with the representative borrower assumption

Author

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  • Rodolphe dos Santos Ferreira

    (BETA - Bureau d'Économie Théorique et Appliquée - AgroParisTech - UNISTRA - Université de Strasbourg - Université de Haute-Alsace (UHA) - Université de Haute-Alsace (UHA) Mulhouse - Colmar - UL - Université de Lorraine - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, Universidade Católica Portuguesa [Porto])

  • Leonor Modesto

    (Universidade Católica Portuguesa [Porto])

Abstract

We examine the relation between intensity of competition in the loan market and risk of bank failure, in a model with adverse selection. As well established, the presence of the two opposite margin and risk-shifting effects creates conditions for nonmonotonicity: the conventional competition-fragility view may be challenged at high interest rates. These rates may however be too high to be compatible with oligopolistic equilibrium conditions. The challenging competition-stability view has been argued in terms of a representative borrower managing the profitability-safeness trade-off under moral hazard. However, the representative borrower assumption is not innocuous, playing down by construction the margin effect. The paper considers the adverse selection situation where that trade-off is managed by banks facing heterogeneous borrowers, and shows analytically, in the case of a trapezoidal distribution of idiosyncratic and systemic risk factors, that the conventional view is always valid.

Suggested Citation

  • Rodolphe dos Santos Ferreira & Leonor Modesto, 2021. "Competition and the risk of bank failure : Breaking with the representative borrower assumption," Post-Print hal-03595060, HAL.
    • Handle: RePEc:hal:journl:hal-03595060
    DOI: 10.1111/jpet.12509
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    References listed on IDEAS

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    Keywords

    Bank failure; Risk; Loan market;
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