Loan Market Competition and Bank Stability : a Re-examination of Banking Competition and Risk Taking

Abstract

The link between banking competition and stability is complex. In 2005, Boyd and De Nicóclo provide a competition-stability model by arguing that competition drives down loan rates and induces less risky investment. This paper introduces a deposit-cost-transmitting mechanism and argues that there is an inverse U-shaped relationship between banking competition and the borrowers` risk-taking behaviors. When banks are equipped with capital-cost transmitting power, great profit margins drive banks to raise loan rates and cause entrepreneurs to choose riskier projects. The environment with higher banking bargaining power tends to be in favor of the competition-fragility view. When banks’ monopoly power is less robust, stiffer competition depresses demand for deposits and decreases both deposit rates and loan rates, inducing the choices of safer projects. Thus, the competition-stability view prevails over the concentration-stability view in a competitive banking system.