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E-MailThe following post comes to us from Robert Bushman, Professor of Accounting at the University of North Carolina at Chapel Hill; and Bradley Hendricks and Christopher Williams, both of the Department of Accounting at the University of Michigan.
How competition affects firm performance is a central question of economics. As in other sectors, competitive pressure in the banking sector can influence the efficiency of bank operations, the quality of financial products, and the extent of innovation. However, unique to the financial sector is the potential link between competition and financial stability. Does bank competition promote financial stability or undermine it by creating incentives for excessive risk-taking? Further, assessing the influence of bank competition on risk-taking behavior is of critical importance to financial analysts, credit rating agencies and investors who seek to forecast banks’ future prospects. This task is perhaps more difficult in banking relative to other industries, given the wide-spread perception that banks are unusually opaque.
In our paper, Perceived Bank Competition: Operational Decision-Making and Bank Stability, which was recently made publicly available on SSRN, we utilize a bank-specific measure that extracts a bank’s perception of its competitive environment from a textual analysis of its 10-K filing. The premise is that managers’ perceptions of the competitive environment influence their operating and risk-taking decisions. We show that this measure is related to future operating performance and bank decision-making in ways that suggest it captures real competitive forces exerting pressure on banks.
Specifically, banks facing higher perceived competition exhibit lower interest margins and loan growth, shift operations towards greater reliance on non-interest sources of income, and place greater emphasis on cost-cutting measures. We find that loan growth of banks confronting higher competition exhibits higher future loan charge-offs relative to lower competition banks, consistent with competition pressuring banks to lower their underwriting standards.
We further find that higher competition is associated with banks arranging syndicated loans for riskier borrowers, reducing the number of covenants in loan contracts and setting interest spreads that are less sensitive to borrowers’ default risk. Beyond operational decisions, competition also affects accounting choices, where the timely recognition of expected loan losses is shown to decrease with competition. Finally, we provide evidence that competition undermines bank stability, finding that higher competition is associated with individual banks having a higher risk of balance sheet contraction and contributing more to systemic risk.
The paper makes several contributions to the literature. Overall, we show that the perceived competition measure has significant explanatory power beyond traditional measures of bank competition, and can serve as a useful complement to the existing measures. Because the measure derives from the point of view of a bank’s decision-makers, it is plausible that this point of view colors the actual decisions made by the bank’s managers. We demonstrate the power of the measure by performing a textured analysis of how bank competition impacts future operating performance and banks’ decisions with respect to pursuing non-interest sources of income, choosing the riskiness of loan portfolios, and designing loan contracts.
We also extend the literature by providing evidence that competitive pressure creates incentives for bank managers to delay recognition of expected loan losses. This is an important result, as prior banking research has shown that delaying expected loss recognition has important implications for credit supply, bank risk shifting, and balance sheet contraction risk and systemic risk. Finally, we are the first to directly test the effects of competition on individual banks’ contributions to systemic risk.
The full paper is available for download here.
