DP11940 | Global Banking: Endogenous Competition and Risk Taking

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Direct involvement of global banks in local retail activities through a “bricks and mortar” business model can reduce risk-taking by promoting local competition. We develop this argument through a dynamic model in which multinational banks may choose to operate in different imperfectly competitive national markets through the horizontal expansion of their deposit and loan activities. In making this choice, banks compare charter values and entry barriers. When foreign operations entail additional monitoring costs, multinational banks face predatory lending incentives that are stronger the smaller their market shares are. The model generates predictions that are consistent with the “bricks and mortar” argument as long as the expansionary impact of competition on multinational banks’ aggregate future discounted profits through larger scale is strong enough to offset its parallel contractionary impact through lower loan-deposit return margin. This effect is stronger with perfectly than imperfectly correlated loans’ risk, with exogenous than endogenous exit, with horizontal than vertical expansion (cross-border lending).