Interbank Competition And Bank Credit Risk

The global financial crisis and its aftermath restarted a debating round relating to the banking system. One dimension of this debate is the effects of interbank competition on bank risk taking behavior and hence on the bank credit risk. In fact, this has been an area of theoretical and empirical academic dedication since1990s where however no consensus has been reached yet. It therefore would be worthwhile to launch a further investigation for a better understanding of the relationship between interbank competition and bank credit risk.Two competing views basically monopolize the previous literature regarding the competition-stability relationship in the banking sector. The traditional view supports that greater bank competition reduces market power and profits margin, which essentially lowers the franchise value of banks. This as a result will increase banks’incentives to take on more risk for profits so as to make up the loss of declined franchise value. On the contrary, the revisionist view argues that more bank competition drags interest rates down, reducing moral hazard and adverse selection problems among borrowers and thus reducing the loan default rates, which benefits the bank soundness. On top of these two camps, Martinez-Mi era and Repullo (2008) document a way to reconcile these two competing views and concludes a U-shape relationship between bank competition and stability.The objective of this thesis is to empirically examine the nature of the relationship between bank competition and bank credit risk---positive, negative or U-shaped---as suggested in theory. We conduct the investigation in the context of banking system within the Euro zone. Among the previous studies, some paper opts for worldwide cross-country sample set to investigate the link between banking competition and stability while others concentrate on a single banking market in a particular country. One problem of the former analysis is lack of comparability across variables due to significant segmentation of banking sectors from one county to another. The later analysis, despite avoiding the concern of comparability, cannot be a convincing proof in general. The banking system within the Euro area provides a fertile ground to address these two backwards since the increased integration, especially the introduction of the euro, levels the playing field which eliminates the separation of banking system to a large extent.Another important issue in testing the theories is the appropriate measures of bank competition and bank credit risk. As noted by many scholars, the structure approach (concentration ratio and Herfindahl-Hirschman index) would not suffice to capture the competition degree due to strong information asymmetry in the banking sector. As for bank credit risk measures, the effective measures are rather rare. This thesis differentiates itself from priori studies in two regards. First, we calculate multiple more precise indices to better capture and to compare the extent to which banks compete within the Euro zone. Second, we launch the empirical examination from the specialized perspective of bank credit risk and focus on the countries in the Euro area where there are lack of detailed research.By way of preview, we find reasonable evidence supporting the traditional view that greater bank competition leads to more bank credit risk. As both competition and credit risk measures put more emphasis on the lending market, the conclusion would hold especially for the loan market within the Euro zone. This beds a tradeoff for the policy makers between competition and credit soundness in the banking industry.