Market Power and Prudence in Dynamic Banking: The Charter Value Theory Revisited

Abstract

Conventional wisdom suggests that fiercer competition for deposits tends to undermine bank prudence. We build a dynamic model of banking and show that the traditional view neglects that banks, when facing tighter margins, also have less room to take reckless risks. As a result, heightened competition can entail more, rather than less, prudence. Yet, at the same time, it tends to make banks more fragile. This is because the direct, destabilizing effect of higher deposit rates outweighs the prudence effect, and, moreover, a substantial rise in competition can reduce banks’ incentive to build precautionary capital buffers. A key implication is that the effects of competition on bank risk-taking and, respectively, failure risk can move in opposite directions.