Through an extensive analysis of theoretical and empirical literature on competition and risk in banking, this document forms the hypothesis that competition and risk are positively correlated. Several factors are discussed that support this hypothesis, including financial liberalization increasing competition and leading banks to take on riskier activities to maintain profits. Deregulation and consolidation in the banking sector are also argued to increase competition and incentivize greater risk-taking by banks. While various perspectives on the relationship between competition and risk are considered, the paper concludes that most evidence favors the view that higher competition induces higher risk in the banking industry.

1. Competition and Risk in Banking
Introduction
The relationship between Competition and Risk in Banking continues to generate debate,
which is indicative of the complexity and varying competing perspectives that surrounds this
subject. The traditional perspective states that when competition increases, bank incentives to
take on more risk increase (Keeley, 1990; Matutes and Vivs, 1996; Hellmann, et al., 2000).
Contrastingly, recent literature has argued that an increase in bank competition would lead to
a decline in the lending rate’s borrowers face. This will result in an increase in profit, thus
lowering a banks incentive to take on risk (Boyd and De Nicolo, 2005). Moreover, Martínez-
Miera and Repullo (2007) adopts both perspectives by suggesting a non-linear relationship
between the two variables. Competition and risk in banking detracts from the traditional
views that competition is healthy, thus this makes the topic and variables of more interest to
study. Competition not only initiates risk-taking behavior in banking, but also impacts
consumers and business’s. In essence, whether it be positive or negative, competition and risk
contributes towards a domino effect within the banking industry and society. This enabled us
to devise a hypothesis as to the relationship between the two variables.
This literature differentiates itself from others as it is modernistic, and requires an analysis of
competing perspectives (Literature) and events (past and present), which in turn will enable
us to consider all relevant information and conclude, as to whether the two variables withhold
a relationship. Moreover, it requires a comprehensive understanding of the topic, which is
used as a vehicle to communicate our hypothesis. Thus, in order to conduct our analysis, we
will use various sources of information and theorists to determine whether variable one
(Competition) affects variable two (Risk).
Literature Review
The potential correlation and effects of competition in the banking sector on banks’ risk-
taking is extremely widespread. In addition, it is very clear that the theoretical underpinnings
surrounding the subject are somewhat contradictory. The traditional view holds that
competition will have a risk-increasing consequence. Contrastingly, recent literature proposes
that risk-taking declines in response to increased competition. Furthermore, modern
literatures have also implied any effects as being non-monotonic. In relation to the traditional
view, the belief is that in banking systems where entry barriers are high and competition is
low, incumbent banks have more market power. This allows them to obtain monopoly rents
from the valuable chartered banks. This results in them being less likely adopt risk-shifting
motivations, as future rents may be in jeopardy as a result of increased default risk. High
competition lowers profits, and thus charter values, consequently making risk-shifting more
appealing.
It’s prominent that a big percentage of this section of the literature links the risk-shifting
enticements of deposit insurance to the risk outcomes of competition. Contributions made by
Keeley (1990), Matutes and Vives (1996) and Allen and Gale (2004) all display supporting
cases; being that the moral-hazardous outcome of deposit-insurance is neutralized by low
competition. Moreover, the consequential risk of competition originates from providing free

2. play to these effects of moral hazard. Comparably, Boyd and De Nicolo (2005) argued that
when deposit insurance is priced fairly, the link between risk and competition is broken
down. Moreover, the disclosing of bank risk by depositors may have a comparable impact as
eradicating (or accurately pricing) deposit insurance (Cordella and Yeyati, 2002).
A comparable line of logic, as the charter-value hypothesis supports the debate that banking
systems that are both less competitive and highly concentrated are less prone to systematic
banking crisis. This is because the increased profits that higher market power and limited
competition imply provides a cushion against adverse shocks, thus seeing a reduction in
systematic risk (Matutes and Vives, 2000). Whilst additional mechanisms have been
proposed, a significant connotation of the competition-fragility view states that banks should
have high valuations and profits. Moreover, any effects that high competition has on risk will
be displayed through relative valuation and profit margins.
The fundamental driver is therefore the mechanism that risk-taking increases when profits
decline. For this mechanism to occur, the assumption that banks control the risk-level of their
portfolio of assets is crucial. Boyd and De Nicolo (2005) believe that the ‘traditional view’ is
mainly the result of placing focus on deposit-market competition and treating bank-assets on
the balance sheet as a portfolio drawback with distributions that have been given
exogenously. Boyd and De Nicolo (2005) advocated an ‘optimal-contracting approach’ in
replace of the contracting approach. This permits competition both in the deposit and loan
market. The setting was one where banks lend to entrepreneurs who then finance risky
projects. The incentives for entrepreneurs to take on risk increases when profitability
declines. However, high loan market competition results in lower lending rates which
decreases entrepreneurs’ risk-taking incentives due higher profits. Moreover, the level of risk
for bank asset portfolios risk will decrease. Whilst the positive impact that deposit market
competition imposes on bank risk remains, the adverse effects of loan-market rivalry
dominate.
Evidence supporting the argument that competition negatively impacts risk may be derived
from the literature composed by Perotti and Suarez (2002). Through conducting an analysis
upon how dynamic settings with endogenized market-concentration provide an incentive for
bank speculative lending; they found that bank incentives to lend prudently increase when
competitors adopt more risk. This outcome derives from the expectation that market
concentration will increase due to the enhanced probability of competitors failing.
Consequently, the surviving banks may see themselves obtaining higher rents in the future.
Conversely, they also propose speculative lending may be enhanced by increased current
market concentration. The mechanism is that the expectancies of a low market concentration
in the future may provide banks with an incentive to amplify the advantages of a temporary
increased share in the market through the short-term rewards of lending speculatively.
In addition, another interpretation states that in banking structures where concentration is
high, with a low quantity of banks that are moderately big and systematically important,
implicit assurances connected with ‘too-big-to-fail’ procedures are more prone. This
encourages banks to form the expectation that they will be bailed out upon default, thus
inducing them to obtain higher risks (Boyd and Runkle, 1993; Mishkin 1999). This therefore
supports the argument that banks should be riskier when situated in markets with low
competition.

3. Thus, literature forecasts that competition has either a positive or negative impact on bank
risk-taking. Further adding to the pre-existing complications surrounding the topic, many
recent contributions suggest the existence of a non-monotonic effect. Through operating the
same system setup as Boyd and De Nicolo (2005), Martinez-Miera and Repullo (2008)
studied loan-market competition in isolation and stated that the outcomes of the latter
significantly center on the belief of loan defaults that are perfectly correlated, and dropping
this statement, displays results that suggest that the relationship between bank risk and
competition is U-shaped. Similarly, several contributions have implicitly and explicitly
displayed the existence of a non-monotonic effects. It has been suggested that the outcomes
of competition depend upon current and competition expected in the future (Perotti and
Suarez, 2002). More commonly, it could be debated that the charter value hypothesis relies
not only on the existence of deposit-insurance-induced moral hazard, but also on the
existence of non-trivial charter values (Forssbaeck and Shehzad, 2011). However,
competition in banking sector is moderately intensive already, the charter value hypothesis
displays very little about the potential outcomes of competition increasing further.
The academic ambiguity with respect to the impacts that competition has on bank risk-taking
is reflected by empirical evidence. The provision of evidence on US data (Keeley, 1990)
normally by relative valuations on proxy competition, reflects the belief that in less
competitive markets, banks should be valued more highly, and discover some indications of
risk and competition being positively associated.
More current results from international and US data are more diverse. For example, tests
conducted by De Nicolo et al. (2004) have suggested that the association between bank risk-
taking and concentration to be positive. This statement therefore contradicts the traditional
hypothesis that enhanced market power should link with decreased risk.
Comparably, using a US dataset and an international set of data of emerging countries, Boyd
et al. (2009) tested how default risk was effected by banking sector concentration (measured
by Herfindahl-Hirschman Index). The results contradict and refute the view of competition-
instability being that the expected impact of concentration on risk is positive. Whilst also
using proxies of competition at country level, but evaluating the impacts of financial stability,
the results found by Beck et al. (2006) are contradictory. They found that on one hand,
elevated market concentration is connected with decreased probability of a systematic crisis.
However, on the other hand, greater (regulatory) barriers of entrance to banking segment
enhance this possibility.
In addition, it has been suggested that the relationship between competition and bank-risk
taking is non-monotonic, but whether the negative or positive impact is dominant relies upon
the risk proxies adopted (Berger et al., 2009). For example, the impacts on default risk are
mainly positive, whereas asset risk is negatively effected by enhanced competition.
Overall it is clear that the results stemming from empirical literature oppose each other. Bank
risk (asset and default) may either increase or decrease when competition is enhanced.
However, the extent to which competition impacts risk is dependent on the context of the
situation. For example, variables such as the the level of development within a country, or the
state of the financial sector may impact the extent to which the two variables are correlated.
Moreover, based on our extensive analysis of literature surrounding the topic, this has lead to
the formation of the hypothesis that; competition in the banking sector is positively
associated with risk.

4. Input
Through conducting an in depth analysis of both theoretical and empirical literatures
surrounding the topic, it is evident that past theorists have contradicting views. However, it
has become apparent that the wide extent of philosophies and evidence in favour of
competition and risk positively affecting one another is sufficiently competent. The following
section of this essay will provide an in-depth analysis and will aid in supporting the
hypothesis that the two variables are positively correlated.
One way in which the positive association between competition and risk can be displayed is
through the event financial liberalization. This is when restrictions on financial markets are
eliminated, or when financial innovations such as subprime loans are introduced to the
market. Research conducted by Demirguc-Kunt and Detragiache (1998) has suggested that a
banking crises has a greater chance of occurring in liberalized financial systems. In addition,
it has been argued that the outcomes of financial liberalization are weaker when imposed
upon fragile banking sectors (Shehzad and Haan, 2008). In relation to our argument, evidence
has shown that financial liberalization results in increased competition, which in general will
tend to squeeze profits in the banking sector. The rapid advancements in technological
processes that have occurred over the past two decades has been a driving catalyst in
changing the culture of banking, thus enhancing the probability of financial liberalization
occurring. With banking now occurring on a global scale, the trends that occur in
international banking have evidently impacted the nature of various banking sectors. For
example, financial innovations have led to the competitive environment within the European
Unions financial sector enhancing. This has seen the size of traditional banking decreasing as
a result of such methods facing a decline in profitability. Consequently, banks have begun
adopting non-traditional methods such as placing a greater percentage of their total funds in
commercial real estate loans, which are traditionally a riskier type of loan (Mishkin et al.,
2013). Banks essentially compensate for lower profits by adopting extra credit risk, in turn
increasing non-performing loans, which have a higher risk of default. This displays that
increased competition may result in banks increasing their level of risk-taking through the
adoption of non-traditional banking methods, thus strengthening the argument made by
Keeley (1990) that competition and risk are positively correlated.
The progression of financial markets facing globalisation has lead to deregulation occurring.
The three phases involved in deregulation result in competition being fuelled by new entrants
from overseas, non-bank financial institutions and non-financial institutions. Banks often
respond to the enhanced levels of competition by developing new business and divert from
traditional banking methods. Non-traditional banking methods can be riskier and result in
excessive risk taking by banks (Mishkin et al., 2013). In addition, evidence supports the
belief that these innovations were responsible for the weakening of bank balance sheets
during the subprime financial crisis. Therefore, in the event of deregulation, banks will
respond to elevated competition levels by raising their level of risk-taking, thus supporting
the hypothesis that competition and risk are positively correlated.
When analysing the relationship between competition and risk, it’s important to note that
internal and external factors within a bank and their sector may impact the extent to which
these two factors are linked. Therefore, various strands of literature have been assessed to aid
in the strengthening of our hypothesis. Securitization may be defined as the process of taking

5. an illiquid asset or group of assets and transforming them into a security. Many theorists have
discovered that the banks whom are active in the market of securitization will respond to
increases in competition by systematically enhancing their risk (Mian and Sufi, 2009;
Nijskens and Wagner, 2011). In addition, Altunbas and Leuvensteijn (2014) also found that
banks resorting more heavily to securitization have higher incentives to increase their risk
profile. Although, the supporting literature used places reliance upon the additional factor of
securitization, this again provides evidence in support of the hypothesis that competition and
risk are positively correlated.
The process of bank consolidation may also be used to further support the argument of
competition and risk being positively associated. The removal of geographic restrictions will
be one of the potential results of banks merging to form larger entities. The consequence of
bank consolidation will see competition rising through the ability of large banks being able to
compete on a global scale, thus leading to a decline in lending to small business’s. Moreover,
banks whom are urgent to expand into new geographic markets may take increased risks
which may result in bank failure (Mishkin et al., 2013). This further supports our hypothesis
by displaying that in response to the consequences of deregulation, globalisation and
financial innovation, enhanced competition will lead to the occurrence of bank consolidation
occurring which can inevitably lead to the banks looking to geographically expand enhancing
their level of risk.
Evidence suggests that competition induces banks to take more risk, which supports our
hypothesis that the two variables are positively correlated. There are various factors
including, liberalisation, deregulation and consolidation of the banking sector, which attribute
a degree of influence upon the two variables. In addition, it is clear that these factors are
significant determinants of competitive related risk. Many theorists including Keeley (1990)
and Mishkin (2013) are concerned heavily with the relationship between the two variables,
often depicting a positive association. Moreover, this section removes any sense of ambiguity
relating to relationship between competition and risk.
Conclusion
Overall, it is clear that the topic of competition and risk is one, which still continues to
generate a major debate within the topic of banking. Some theorists believed that an increase
in competition lead to the enhancing of bank risk (Keeley, 1990), whereas others argued that
an increase in competition lead to a decrease in risk (Boyd and De Nicolo, 2005). We found
using a vast level of pre-existing research surrounding competition and risk that there is an
extensive level of both theoretical and empirical evidence in support of Keeley (1990). As a
result, this led to the formation of the hypothesis that competition and risk are positively
correlated. However, whilst competition and risk may be displayed as being positively
correlated, there are many differentiating factors, which contribute to this relationship
occurring. In addition, the extent to which the two variables impact one another can be
attributed to a series of external factors. For example, the occurrence of globalisation and
internationalisation of the financial sector has lead to deregulation and financial innovations
occurring. The result of this has seen competition enhancing for banks in which they respond
by increasing their level of risk-taking, thus highlighting a positive association. It is important
to note that external factors such as a financial crises or the development of a country can
impact the extent to which competition occurs and the degree in which bank risk transforms.

6. This essay provides a competent exploration into the extensive debate of competition and
risk; however, there are some limitations to this literature. Firstly, whilst this paper has relied
upon the use of a large amount of literature to form its hypothesis, the financial sector is
constantly changing. As a result, a limitation is that some of the pre-existing literatures used
within this essay may not be relevant as they are based upon the events which occurred in a
financial sector that is very different to the one that currently exists today.
A second limitation is that whilst this paper covers a wide range of literature to help provide
an argument in favour or against the link between competition and risk, the theories used
cover a wide range of events and contexts, thus limiting the potential breakdown and impacts
upon which each context may have on competition and risk. Therefore, when conducting
future research, one may place the focus of the literature used on only one context such as the
financial crisis and or globalisation, to provide an investigation into how this factor impacts
the correlation between competition and risk in banking.
The third limitation can be drawn from this essay failing to incorporate any numerical
figures in order to conduct a regression analysis. The use of such tools would aid in providing
a visual and more in-depth analysis about the extent to which the variables competition and
risk are linked. When conducting further research, the application of a regression analysis
through the obtainment of numerical figures may aid in providing a more advanced insight
into the topic of competition and risk and assist in establishing the extent in which the two are
linked. Furthermore, the successful application of the Lerner index in future research will aid
in identifying the exact degree of competition that exists in a specific banking market. This
will consequently allow one to accurately discover the level of risk that exists at this level of
competition, and how fluctuations in competition impact risk, thus displaying whether the
two are positively correlated.

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