Competition and bank fragility

We present empirical evidence documenting how increased competition can affect the fragility of banks using U.S. banking data from 1990 to 2005. In particular, using data from the Federal Financial Institutions Examination Council (FFIEC) Call Reports we find that local banks belonging to community (CBOs) and regional banking organizations (RBOs) increased their share of commercial real estate (CRE) loans as competition from large banking organizations (LBOs) increased. The paper traces the build-up in CRE concentrations in such local banks before the financial crisis to the expansions of LBOs into local banking markets. Later, we instrument for LBO competition using branching data from the Federal Deposit Insurance Cooperation (FDIC)’s Summary of Deposits data to measure distance between small banks and their nearest large bank competitor branches. After instrumenting for LBO competition, we find a steady and continuous increase in CRE loan shares at local banks. CRE concentrations were a principal cause of post-crisis bank failures, and this paper presents evidence showing how competition has the potential to increase not just individual bank fragility, but the overall stability of the banking sector. We do so by tracing the channels through which this competition may affect bank behavior. In particular, we show that LBOs entering small bank markets were able to capture residential mortgage market share using the Federal Reserve’s Home Mortgage Disclosure Act (HMDA) data, likely pushing small banks to take on additional concentration risk. It was through this channel that large banks were able to leverage their technological and funding advantages. By responding as they did, CBOs and RBOs increased their balance sheet concentration to specific asset price shocks that later materialized during the crisis. As such, we highlight one way in which competition can destabilize the financial system.