Competition, moral hazard, and credit crunch: Three essays on banking

Modern financial theory identifies two conflicting forces that influence the level of bank lending during a banking crisis: “credit crunch” and “moral hazard.” The credit crunch story suggests that as a bank's net worth deteriorates, it will reduce its level of lending. The moral hazard explanation emphasizes bank incentives to increase risky loans when they are insolvent or nearing insolvency. Theses two conflicting forces may be operating simultaneously in a banking crisis period. In the past literature, however, neither theoretical nor empirical research has ever separated out these two forces.; The first chapter of this thesis provides a theoretical model so that we could capture the two opposite forces. In the model, n banks compete in a Cournot fashion for lending to a borrower. Moral hazard and credit crunch effects are identified in this oligopoly setting. The model also implies that the degree of competition in a lending market influences these two effects.; The second chapter empirically tests the two forces. Since one would need information not only on banks, but on borrower-bank pairs to distinguish varying risks of borrowers, previous empirical research has been unable to sort out the moral hazard and credit crunch effects. This chapter seeks to fill in this gap by matching Japanese bank and borrower data. I find both effects are present. Empirical results also imply that a weaker bank's loan portfolio has been more skewed toward risky borrowers.; The third chapter investigates signaling about a borrower's credit quality from an informed bank to uninformed banks. As Rajan (1992) suggests, banks may be distinguished into informed (insider) and uninformed (outsider) banks in terms of monitoring intensity and information flow. However, one may often argue that informed banks somehow reveal their borrower's information through signals. This chapter seeks for empirical evidence of signaling a borrower's information from more informed to less informed banks. The results provide no supporting evidence for the signaling effects.