11 - Competition and bank performance: a theoretical perspective

Summary

Introduction

Banks serve as financial intermediaries between borrowers and lenders. More precisely, banks borrow from depositors and lend to investors. In this financial intermediation role, banks perform (at least) two important functions. First, banks insure depositors, who could in principle lend directly to borrowers, against the risk of default. Second, in the process of approving loans and setting terms, banks screen investment projects. This paper is concerned with how well banks perform this second function, and with how performance depends on market structure.

In a capitalist economy most investment projects are owned and managed by private entrepreneurs and firms. Generally these investors lack enough equity fully to finance their projects and consequently seek loans to complete financing. Banks, on the other hand, aggregate deposits to make these loans. In choosing which loans to make, banks play a crucial role in determining the investment portfolio of the economy.

The loan-making decisions of banks depend on many factors. Among these are banks' assessments of the creditworthiness of a borrower and the intrinsic merit of an investment project. Banks screen loans to reduce the risk of default. The loan approval practices of banks are endogenous, however, depending on the structure of loan markets, and in particular on the nature and degree of competition.

The performance of the banking system also depends on many factors. Among these are (1) how well the banking system utilizes information about investment risks in making loans, and (2) to what extent the loan-making incentives of banks are aligned with society's interest. The analysis that follows demonstrates how these two factors are crucial for an understanding of how competition matters for bank performance.