Market concentration and commercial bank loan portfolios

This paper estimates the relationship between banking market concentration and high-risk portfolio strategies at commercial banks. I use the unprecedented changes in the degree of competition in local banking markets that occurred after 1980 to estimate the impact of market competition on the risk profile of commercial bank lending. I find evidence that increasing concentration has been associated with reductions in the flow of bank capital to construction and land development loans, the highest-risk category of commercial bank loans. The magnitude of this effect is large: an increase in concentration from the 25 to the 75 percentile of the sample distribution is associated with a 15 percent drop in the share of bank lending going to construction loans. Robustness to a variety of econometric strategies supports a causal interpretation of this empirical relationship. Increasing concentration also appears to increase average bank capitalization, raise the average share of assets loaned out to borrowers, and reduce bank failure rates during this period. Because the Federal Deposit Insurance Corporation assumes the assets and liabilities of failing banks, changes in bank portfolio risk affect the value of the government’s contingent liability to the banking sector, as well as the health and stability of the larger economy.