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Deposit competition and loan markets

Stefan Arping

Journal of Banking & Finance, 2017, vol. 80, issue C, 108-118

Abstract: Less-intense competition for deposits, by mitigating banks’ incentive to take excessive risks, is traditionally believed to lead to lower non-performing loan (NPL) ratios and more-stable banks. This paper revisits this proposition in a model with borrower moral hazard in which banks’ NPL ratios depend endogenously on their loan pricing. In relatively uncompetitive loan markets, less-fierce competition for deposits (i.e., lower deposit rates) leads to lower loan rates and, thus, safer loans. In more-competitive markets, the opposite can occur: As banks’ deposit-repayment burdens decline, they become less eager to risk-shift; this softens competition for risky loans, leading to higher loan rates and, ultimately, riskier loans. Overall, the model predicts a hump-shaped relationship between banks’ pricing power in deposit markets and their NPL ratios.

Keywords: Bank competition; Loan pricing; Financial stability (search for similar items in EconPapers)
JEL-codes: G2 G3 L1 L3 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:jbfina:v:80:y:2017:i:c:p:108-118