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Competition and the risk of bank failure: Breaking with the representative borrower assumption
Author(s) -
Dos Santos Ferreira Rodolphe,
Modesto Leonor
Publication year - 2021
Publication title -
journal of public economic theory
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.809
H-Index - 32
eISSN - 1467-9779
pISSN - 1097-3923
DOI - 10.1111/jpet.12509
Subject(s) - adverse selection , moral hazard , profitability index , margin (machine learning) , economics , competition (biology) , loan , fragility , oligopoly , microeconomics , selection (genetic algorithm) , monetary economics , incentive , macroeconomics , finance , ecology , chemistry , machine learning , artificial intelligence , cournot competition , computer science , biology
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.