Bank Competition: Measurement, Decision‐Making, and Risk‐Taking

• Author: BRADLEY E. HENDRICKS,ROBERT M. BUSHMAN,CHRISTOPHER D. WILLIAMS
• DOI: http://doi.org/10.1111/1475-679X.12117
• Date: 01 June 2016
• Published date: 01 June 2016

DOI: 10.1111/1475-679X.12117

Journal of Accounting Research

Vol. 54 No. 3 June 2016

Printed in U.S.A.

Bank Competition: Measurement,

Decision-Making, and Risk-Taking

ROBERT M. BUSHMAN,

∗BRADLEY E. HENDRICKS,

∗

AND CHRISTOPHER D. WILLIAMS

†

Received 29 January 2013; accepted 14 November 2015

ABSTRACT

This paper investigates whether greater competition increases or decreases

individual bank and banking system risk. Using a new text-based measure

of competition, and an instrumental variables analysis that exploits exoge-

nous variation in bank deregulation, we provide robust evidence that greater

competition increases both individual bank risk and a bank’s contribution

to system-wide risk. Specifically, we find that higher competition is associ-

ated with lower underwriting standards, less timely loan loss recognition, and

a shift toward noninterest revenue. Further, we find that higher competi-

tion 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

∗Kenan-Flagler Business School, University of North Carolina at Chapel Hill; †Ross School

of Business, University of Michigan.

Accepted by Christian Leuz. We wish to thank two anonymous referees, Mike Minnis,

Stephen Ryan, Derrald Stice, Larry Wall, Jieying Zhang (discussant), and workshop partic-

ipants at Carnegie Mellon, Duke/UNC Fall Camp, Georgetown University, National Uni-

versity of Singapore, New York University, HKUST Accounting Symposium, London Busi-

ness School Accounting Symposium, Northwestern University, Seoul National University,

Singapore Management University SOAR Accounting Conference, University of Chicago,

and University of Toronto for helpful comments. We thank Jeffrey Hoopes and Feng

Li for help in computing the competition metric. R. M. Bushman and B. E. Hendricks

thank Kenan-Flagler Business School, University of North Carolina at Chapel Hill. C.

D. Williams thanks both the PriceWaterhouseCoopers–Norm Auerbach Faculty Fellowship

and the Arnold M. and Linda T. Jacob Faculty Fellowship for financial support. An on-

line appendix to this paper can be downloaded at http://research.chicagobooth.edu/

arc/journal-of-accounting-research/online-supplements.

777

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

778 R.M.BUSHMAN,B.E.HENDRICKS,AND C.D.WILLIAMS

greater contribution by individual banks to downside risk of the banking sec-

tor.

JEL codes: G20; G21; L10; M40; M41

Keywords: banking; competition; risk; textual analysis

1. Introduction

Banks play a central role in the financial system. Of particular concern

to bank regulators is excessive risk-taking by individual banks and bank-

ing system vulnerabilities due to correlated risk-taking across banks (e.g.,

Acharya et al. [2010], Hanson, Kashyap, and Stein [2011]). An important

unresolved issue is the extent to which bank competition mitigates or exac-

erbates financial stability. Theory provides competing hypotheses on this

issue. At one extreme, the competition–fragility hypothesis posits that

downward competitive pressure on bank profits reduces charter value and

creates incentives for excessive bank risk-taking (e.g., Keeley [1990], Allen

and Gale [2000, chapter 8]). In contrast, the competition–stability hypoth-

esis posits that banks with greater market power charge higher rates, which

induces borrowing firms to take on greater risk and increases the risk of

banks’ loan portfolios. This leads to the hypothesis that banks become less

risky as competition increases (Boyd and De Nicolo [2005]). While prior

literature explores these hypotheses, the evidence is inconclusive.1

Using both a new text-based measure of competition and an instrumental

variables analysis that exploits exogenous variation in bank deregulation,

this paper investigates whether greater competition increases or decreases

individual bank and banking system risk. We provide robust evidence that

risk at the individual bank level and a bank’s contribution to system-wide

risk increase with competition. Specifically, we find that competition is as-

sociated with significantly higher risk of individual banks suffering severe

drops in their equity and asset values. At the system level, higher compe-

tition is associated with significantly higher co-dependence between down-

side risk of individual banks and downside risk of the entire banking sector.

We also investigate key decision-making channels through which compe-

tition can operate to increase the overall riskiness of banks. We find that

higher competition is associated with lower underwriting standards, less

timely accounting recognition of expected loan losses, and a greater re-

liance on noninterest sources of income.

As Beck [2008] notes, there is no agreement about how best to mea-

sure competition. Two important classes of bank competition measures

are (1) measures of industry structure, and (2) measures that infer mar-

ket power without regard to industry structure (e.g., Berger et al. [2004],

1See reviews by Beck [2008], Carletti [2008], and Degryse and Ongena [2008], and the

discussion in Berger et al. [2004].

BANK COMPETITION 779

Beck [2008], Degryse and Ongena [2008]). Industry structure measures

(e.g., Herfindahl–Hirschman indices) require industry membership to be

explicitly defined, making it difficult to capture competition deriving from

potential entrants and nonbanks. These measures also rely on the restric-

tive assumption that all industry members are continuously subjected to

identical levels of competition.2In contrast, measures of market power di-

rectly examine relationships between factor input and output prices. For

example, the Lerner index is a bank-specific measure that estimates the

gap between marginal revenues and costs.3Its construction requires esti-

mation of cost function parameters using historical accounting data in a

pooled industry regression. Reliance on historical data raises the possibility

that Lerner indices are sluggish in capturing recent changes in competi-

tion, and pooled industry estimation assumes that all banks in a researcher-

defined industry have identical cost function parameters.

In this paper, we do not use either industry structure or market power

measures to capture competition. Rather, we capture competition using

a bank-specific measure of competition extracted from banks’ 10-K fil-

ings (Li, Lundholm, and Minnis [2013]) that we show captures exoge-

nous changes in barriers to entry. The premise of this text-based mea-

sure, bank’s competitive environment (BCE), is that it captures managers’

current perceptions of competitive pressures deriving from any and all

sources, including potential entrants, nonbank competitors, and labor mar-

kets. Further, BCE can capture evolving competitive pressures that are

not yet fully reflected in a bank’s past performance. This measure allows

for competitive pressure to vary both across banks in a given year and

across years for a given bank due, for example, to differences in geo-

graphic footprints (Dick [2006]), business models (Altunbas, Manganelli,

and Marques-Ibanez [2011]), or product-line mixes (Bolt and Humphrey

[2012]).4Further, it requires no equilibrium assumptions, no definition of

market boundaries, and no restrictive assumptions about bank cost func-

tions.

Li, Lundholm, and Minnis [2013] make a case for the validity of this

text-based measure for nonfinancial firms. Controlling for industry-level

competition, they find that firm profitability mean reverts more quickly for

2Further, it is not clear whether industry structure determines bank behavior or is itself the

result of bank performance (e.g., Cetorelli [1999], Berger et al. [2004], Claessens and Laeven

[2004]).

3A larger gap implies more market power.Another measure of market power is the Panzar–

Rosse H-statistic (e.g., Claessens and Laeven [2004], Bikker, Shaffer, and Spierdijk [2012]). In

contrast to the Lerner index, the H-statistic is difficult to estimate at the individual bank level

and is typically estimated at the industry level.

4This measure need not be symmetric across banks. For example, consider a bank holding

company with branches in many geographically dispersed markets and a small bank operating

in one local market. While the small bank may report facing intense competition, its single

market is a small part of the large bank’s geographic scope and may have little influence on

perceptions of competition from the overall bank holding company’s perspective.