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

Rodolphe Dos Santos Ferreira and Leonor Modesto

Journal of Public Economic Theory, 2021, vol. 23, issue 4, 622-638

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.

Date: 2021
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https://doi.org/10.1111/jpet.12509

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Working Paper: Competition and the risk of bank failure: Breaking with the representative borrower assumption (2021)
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