Banking industry concentration, bank risk-taking and loan pricing: An empirical investigation

The present study explores how the market power of commercial banks in loan markets influences their risk-return trade-off and their risk-return choices inherent in their loan pricing decisions. As a bank raises the contractual interest rate it charges on loans, the quality of its applicants' declines, which defines a basic trade-off between a higher expected rate and a commensurate increase in risk. An increase in market power in its loan markets improves the trade-off: for any contractual rate the bank can charge, its expected return is higher because the increased market power reduces the expected loss rate (adverse-selection-market-power effect). The effect of the increased market power on the rate the bank charges depends on the bank's risk-taking incentives. The improved trade-off increases the expected return to risk-taking. However, the better trade-off also increases the potential value ("charter value") of the bank and, by giving the bank more to lose in insolvency, tends to reduce its incentive to take risk (charter-value effect).; We use a simultaneous equation model, composed of three equations, to capture the influence of market power on banks' expected return-risk menu and on bank managers' incentives to undertake risk implicit in their loan pricing decisions. In the equation system, two equations characterize bank managers' risk-taking behavior and the third equation characterizes the risk-return tradeoff banks face. The structure of the empirical model allows us to isolate the market power induced charter value effect on loan prices. This effect is captured by a variable in the behavioral equations that denotes banks' potential value, which in turn is estimated using stochastic frontier based regression techniques. Also, the adverse-selection-market-power effect and its consequent influence on loan prices can be empirically ascertained.; Using financial data for the top-tier US bank holding companies for the years 1995, 1996, and 1997 the structural model is estimated using instrumental variables techniques. Our findings suggest that banks with market power experience an increase in their relative charter value, face improved expected risk-return choices, exercise market power in pricing loans, and assume lower credit risk. However, we do not find evidence that the charter value effect on loan prices is statistically significant.