DP1665 | Bank Solvency, Market Structure, and Monitoring Incentives

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We analyse the impact of market structure on the probability of banking failure when banks? loan portfolios are subject to aggregate uncertainty. In our model borrowers are subject to a moral hazard problem, which induces banks to choose between two second-best alternative devices: costly monitoring and credit rationing. We show that investment depends on both the lending rate and the information structure. Since monitoring incentives increase with interest rate margins, the relationship between market structure and investment is ambiguous. Also, larger investment levels imply that the expected return of marginal projects is lower and thus banks? portfolios are more vulnerable to aggregate uncertainty. Consequently, a monopoly bank monitors borrowers more intensively, rations the amount of credit less frequently and hence may go bankrupt with higher probability than competitive banks.