Banking Competition, Moral Hazard and Leverage

Abstract

A large body of literature has blamed moral hazard behaviour by banks, for triggering the recent global financial crisis. Many reasons have been cited for such incentive distortion, e.g. the originate-to-distribute approach, regulatory capital arbitrage or the possibility of systemic bailouts. These motives were stoked by a low interest rate regime, in the wake of free inflow of capital in advanced economies. In contrast, we show that domestic banking competition, per se, reduces monitoring and fuels risky lending booms. Therefore, we claim that the incentive problem is due to banking competition, rather than bailout guarantees or capital account liberalization.