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

• Published in: Journal of public economic theory Vol. 23; no. 4; pp. 622 - 638
• Main Authors: Dos Santos Ferreira, Rodolphe, Modesto, Leonor
• Format: Journal Article
• Language: English
• Published: Oxford Blackwell Publishing Ltd 01-08-2021; Wiley
• Subjects: Adverse selection; Bank failures; Business administration; Competition; Economic theory; Economics and Finance; Humanities and Social Sciences; Loan market; Bank failure; Risk
• ISSN: 1097-3923; 1467-9779
• DOI: 10.1111/jpet.12509

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.