This article presents a model in which, contrary to conventional wisdom, competi- tion can make banks more reluctant to take excessive risks: As competition intensifies and margins decline, banks face more-binding threats of failure, to which they may respond by reducing their risk-taking. Yet, at the same time, banks become riskier. This is because the direct, destabilizing effect of lower margins outweighs the disciplining effect of competition; moreover, a substantial rise in competition reduces banks incentive to build precautionary capital buffers. A key implication is that the effects of competition on risk-taking and on failure risk can move in opposite directions.
Charter Value Hypothesis Bank Franchise Value Bank Competition Financial Stability Capital Requirements