Does Competition Reduce the Risk of Bank Failure

Abstract

A large theoretical literature shows that competition reduces banks’ franchise values and induces them to take more risk. Boyd and De Nicolò (2005) contradict this result: When banks charge lower rates, their borrowers have an incentive to choose safer projects, so they will in turn be safer. However, this result does not take into account the fact that lower rates also reduce the banks’ revenues from non-defaulting loans. This paper shows that when this effect is taken into account, a U-shaped relationship between competition and the risk of bank failure generally obtains.