Following the 2008 global financial crisis, central banks and global regulators often faced a fundamental dilemma: should we curb banking competition to preserve financial stability? Economists have long debated this through two clashing lenses: 

• The Competition-Fragility View: Fierce market competition squeezes profit margins and erodes "charter values," pushing banks into riskier territory to maintain payouts. 

• The Competition-Stability View: More competition lowers loan interest rates, reducing default risk and moral hazard among borrowers, thereby stabilizing the system. 

In a landmark study titled “Does competition affect bank risk?” published in the Journal of Money, Credit and Banking, Prof. Liangliang Jiang from the School of Accounting and Finance (AF) at The Hong Kong Polytechnic University (PolyU), along with co-authors Prof. Ross Levine and Prof. Chen Lin, provides compelling empirical clarity on this long-standing debate.

The Core Insight & Analytical Approach

Past empirical studies yielded conflicting results primarily because measuring true competitive pressure is notoriously difficult. Traditional studies looked at broad state-level deregulations or accounting indicators (like the Lerner Index), which often suffered from data limitations, unobserved local economic shocks, or reporting biases. 

To solve this, the research team pioneered a highly precise Bank-Specific, Regulation-Induced Competition Measure. By dynamically tracking the historical timeline of U.S. interstate banking deregulation alongside the Gravity Model of Investment—which states that a bank expands more easily into geographically closer markets—the authors calculated a unique competitive pressure index for each individual bank holding company based on its branch network's distances to out-of-state entry points. 

Crucially, by shifting from a broad state-year level to a granular bank-year level, the study successfully filters out omitted state-level economic trends. Furthermore, rather than relying on historical accounting metrics that banks can easily manipulate under stress, the team used forward-looking market-based risk metrics (such as Total Stock Return Volatility and Tail Risk) to immediately and accurately capture shifting risk profiles. 

Key Findings & Systemic Mechanisms
The rigorous analysis reveals a definitive conclusion: An intensification of competition materially and substantially boosts bank risk . Moving a bank from a low-competition environment to a high-competition one spikes its Total Risk and Tail Risk metrics by approximately 50%. 

The paper unpacks the underlying corporate mechanisms driving this risk expansion:

1. Profit Compression: Heightened competitive pressures severely deplete a bank's Return on Assets (ROA), compress Net Interest Margins (eroding pricing power), and diminish charter values.
   
   
2. Shift to Nontraditional Activities: As profit margins on traditional commercial lending shrink, banks aggressively expand into riskier, noninterest-generating business lines, including complex trading, derivatives portfolios, and investment underwriting services.
   
   
3. Riskier Credit Allocations: Squeezed commercial margins force banks to lower credit underwriting standards and extend loans to significantly riskier, smaller, and less profitable borrowers. 

The paper finds strong evidence of an trade-off between open-market banking efficiency and micro-prudential financial stability. While dismantling regulatory barriers can stimulate local financial efficiency and benefit consumers, it simultaneously erodes franchise values and incentivizes banks to step up speculative risk-taking.

Consequently, if regulators choose to liberalize banking sectors, they must concurrently implement more stringent capital buffers, enhanced transparency rules, and robust oversight mechanisms to counteract the systematic buildup of hidden portfolio risks.

Keywords:  Competition, Bank risk-taking, Bank deregulation

Research Paper: Jiang, Liangliang, Ross Levine, and Chen Lin. “Does competition affect bank risk?” Journal of Money, Credit and Banking, 2023, 55(5), 1043-1076.

👉Read the full article here: https://doi.org/10.1111/jmcb.12990