How does competition impact bank risk - taking? Malaysian perspective

Abstract

A common assumption in the academic literature and in the actual supervision of banking systems worldwide is that franchise value plays a key role in limiting bank risk-taking. As the underlying source of franchise value is assumed to be market power, reduced competition has been considered to promote banking stability. In contrast, there is an alternative view that concentration in the loan market could lead to increase in borrower debt loads and a corresponding increase in loan defaults that would undermined bank stability. There is also a third assumption that encompasses both the above approaches that a nonlinear relationship exists between competition and bank risk-taking. Using the datasets extracted from the Malaysian banks including foreign owned banks, incorporated in Malaysia, we examine the empirical nature of the relationship between competition and bank risk-taking. From the study, using Lerner indexes based on bank specific loan and deposit interest rates to measure market power, we find negative relationships between both the loan and deposit market power and bank risk, measured by the ratio of non-performing (NPL). This result provides evidence in favor of the franchise value paradigm.