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

Rodolphe Dos Santos Ferreira and Leonor Modesto

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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.

Keywords: Bank failure; Risk; Loan market (search for similar items in EconPapers)
Date: 2021-08
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Published in Journal of Public Economic Theory, 2021, 23 (4), pp.622-638. ⟨10.1111/jpet.12509⟩

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Journal Article: Competition and the risk of bank failure: Breaking with the representative borrower assumption (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03595060

DOI: 10.1111/jpet.12509

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