Bank Competition: Measurement, Decision-Making, and Risk Profiles

Abstract

This paper investigates how competition impacts the future operating decisions and risk profile of banks. We construct a comprehensive, time-varying, bank-specific measure of a bank’s competitive environment (BCE) using textual analysis of banks’ 10-K filings. Using U.S. branch banking deregulation to capture exogenous changes in threats of entry, we provide evidence that BCE is a timely measure of real competitive pressures by showing that it significantly increases following decreases in barriers to entry. Measuring competition with BCE, we find that higher competition is associated with lower underwriting standards, less timely loan loss recognition and a shift towards non-interest revenue. Further, we find that higher competition is associated with higher stand-alone risk of individual banks, greater sensitivity of a bank’s downside equity risk to system-wide distress, and a greater contribution by individual banks to downside risk of the banking sector. We then show that these results using BCE are largely robust to replacing BCE with branch bank deregulation. Finally, we show that our BCE results hold in a post-deregulation analysis restricted to time periods following the final deregulation event in each state. These results combine to suggest that competition increases the risk profile of banks and that BCE can be of value to researchers and analysts for measuring competitive pressure at any point in time, regardless of the existence of a regulatory event.