The Theory of Bank Risk-Taking and Competition Revisited

There is a large literature that concludes that—when confronted with increased competition—banks rationally choose more risky portfolios. We argue that this literature has had a significant influence on regulators and central bankers. We review the empirical literature and conclude that the evidence is best described as “mixed.” We then show that existing theoretical analyses of this topic are fragile, since there exist fundamental riskincentive mechanisms that operate in exactly the opposite direction, causing banks to become more risky as their markets become more concentrated. These mechanisms should be essential ingredients of models of bank competition. * John H. Boyd is Kappel Chair in Business and Government, Finance Department, University of Minnesota. Gianni De Nicoló is Senior Economist in the Monetary and Financial Systems Department of the International Monetary Fund. The views expressed in this paper are those of the authors and do not necessarily represent the views of the International Monetary Fund or of the Federal Reserve System.