Competition and Risk Taking in Banking : The Charter Value Hypothesis Revisited

Greater competition in banking is traditionally believed to aggravate banks' incentive to take excessive risks. This paper presents a model in which, contrary to the traditional view, an increase in competition can cause banks to behave more prudently: As competition intensifies and margins decline, banks face more-binding threats of failure, to which they may respond by reducing loan portfolio risk. Nonetheless, competition is unambiguously destabilizing in this model: The direct, destabilizing effect of lower margins outweighs the prudence effect; moreover, a substantial rise in competition can reduce banks' incentive to build precautionary equity capital buffers. A key implication is that the effects of competition on bank risk taking and on failure rates can move in opposite directions