Bank risk‐taking in a mixed duopoly: The role of the state‐owned bank

• Published date: 01 December 2022
• Author: Ping‐Lun Tseng,Wen‐Chung Guo
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/irfi.12366

ORIGINAL ARTICLE

Bank risk-taking in a mixed duopoly: The role of

the state-owned bank

Ping-Lun Tseng

1

| Wen-Chung Guo

2

1

College of Business, National Taipei

University of Business, Taipei City, Taiwan,

Republic of China

2

Department of Economics, National Taipei

University, New Taipei City, Taiwan, Republic

of China

Correspondence

Ping-Lun Tseng, College of Business, National

Taipei University of Business, NO. 321, Sec.

1, Jinan Rd., Zhongzheng Dist., Taipei City

100, Taiwan, Republic of China.

Email: 94352508@nccu.edu.tw

Abstract

We analyze the role of a state-owned bank, whose objec-

tive is to maximize social welfare, in a credit market with a

mixed duopoly. The equilibrium reveals that the state-

owned bank is exposed to lower credit risk than the private

bank. Furthermore, when the deposit rate is raised by the

monetary authority, both banks exert socially beneficial

higher monitoring efforts. In modified models, we explore

the effects of the cost-inefficiency and the political view of

the state-owned bank. Extensions on partial nationalization,

mixed oligopoly with multiple private banks, and the case

of loan differentiation with price competition are also

discussed.

KEYWORDS

credit market, mixed duopoly, risk-taking, state-owned bank

JEL CLASSIFICATION

D43; G21; L32

1|INTRODUCTION

This study attempts to analyze the role of state-owned banks in bank risk-taking in a credit market with a mixed

duopoly. In the existing literature, while some empirical studies report that state-owned banks are more inefficient,

less profitable, and riskier (Berger et al., 2005; Boubakri et al., 2020; Cornett et al., 2010; Iannotta et al., 2007;

Iannotta et al., 2013; La Porta et al., 2002; Micco et al., 2007); others document that there is no significant difference

in efficiency, profitability, or riskiness between state-owned banks and private banks (Altunbas et al., 2001; Cornett

We are deeply grateful to the editor Steven Ongena, one anonymous associate editor, and an anonymous reviewer for theirvaluable suggestions. All

remaining errors are ours.

Received: 20 May 2020 Revised: 16 April 2021 Accepted: 10 August 2021

DOI: 10.1111/irfi.12366

© 2021 International Review of Finance Ltd.

688 International Review of Finance. 2022;22:688–724.

wileyonlinelibrary.com/journal/irfi

et al., 2010; Laeven, 1999; Micco et al., 2007; Shen et al., 2014). Furthermore, a growing literature emphasizes that

the role of state-owned banks may be beneficial for economic growth, financial stability, and social welfare

(Andrianova, 2012; Andrianova et al., 2008; Andrianova et al., 2012; Bose et al., 2014). On the other hand, credit risk

has received much attention from both academics and practitioners in recent years as one of the essential causes of

the 2007–2008 financial crisis. The following government bailout and intervention reinforce the urgency of reaching

a full understanding of the role of state-owned banks. As a result, our study is motivated not just by the limited theo-

retical works analyzing credit risk and bank competition in a mixed oligopoly, and by the common phenomenon of

state-owned banks in EU countries, China, India, and numerous transition economies (La Porta et al., 2002), but also

by the role of state-owned banks in the aftermath of the 2007–2008 financial crisis (Andrianova et al., 2012;

Iannotta et al., 2013).

Our work makes two main contributions to the literature. First, to the best of our knowledge, this work is the

first to discuss the role of state-owned banks by endogenizing both lending behavior and monitoring decisions. This

endogenization enables us to explore the interaction between state-owned banks and private banks and how it

affects lending behavior and risk-taking of these two types of banks. Our study contributes to complement past

studies that consider only either lending behavior (Bose et al., 2014; Brei & Schclarek, 2015; Saha &

Sensarma, 2013) or risk-taking (De Fraja, 2009).

Second, while studies on the relationship between competition and risk-taking among private banks are over-

whelmingly numerous (Allen & Gale, 2004; Boyd & De Nicolo, 2005; Gomez & Ponce, 2014;Keeley,1990;

Martinez-Miera & Repullo, 2010;Wagner,2010), much empirical research has documented that state-owned

banks behave quite differently from private banks and become more emphasized in many countries after the

2007–2008 financial crisis as mentioned in the beginning. We thus extend our mixed duopoly model to explore

the effects of cost-inefficiency, of political view, and of partial nationalization on bank lending and risk-taking,

respectively, and provide a raw picture to policymakers in countries where the banking industry is undergoing

nationalization.

We first establish a basic model of credit market competition in which banks finance borrowers' projects with

loans and can improve performance of their loan portfolios through involving supervisory monitoring efforts.

1

Here we consider a loan market with one state-owned bank and one private bank who engage in Cournot-type

quantity competition. Both banks raise deposits to finance borrowers under deposit insurance. The state-owned

bank maximizes social welfare, which consists of profits of both banks, borrower surplus (or entrepreneur sur-

plus), and total losses resulting from project default, while the private bank maximizes only its own profit. In such

an environment, the total lending determines the loan rate, which is the repayment both banks obtain when pro-

jects underlying their loans succeed, and thus affects the levels of their monitoring efforts. The magnitude of the

borrower surplus depends not only on the amount of bank lending but also on the successful probability of

projects.

We start by characterizing the equilibrium of the mixed duopoly, and show that th e state-owned bank is

exposed to lower risk than is the private bank. This is because the state-owned bank takes into consideration

the social welfare, and thus chooses a higher level of monitoring than does the private bank, due to the socially

beneficial effects of monitoring on reducing default losses and on enhancing borrower surplus. Besides, when

welfare of lending is small (i.e., lower returns of projects with higher funding cost and monitoring cost), the

state-owned bank makes fewer loans than does the private bank. As a result, a lower amount of total lending

and a higher loan rate occur, leading to higher monitoring incentives for both banks comparedto those in a sym-

metric duopoly. This result is consistent with the view of financial stability by state-owned banks in

Andrianova (2012).

Moreover, an increase in the deposit interest rate increases monitoring incentives of both banks and decreases

their credit risks. This is because the state-owned bank reduces lending and exerts a higher monitoring effort so as

to increase profits of both the private and the state-owned banks as well as borrower surplus, and to decrease

default losses from total lending when the cost of deposits by the monetary authority is increasing. Furthermore, the

TSENG AND GUO 689

state-owned bank cuts lending much more than does the private bank that decreases lending only to maximize its

profits under higher funding cost. This effect increases the loan rate and thus induces the private bank to exert a

higher monitoring effort, and the private bank will take advantage of imperfect competition and strategically increase

lending in order to capture borrower surplus. However, imperfect competition only allows the private bank to exploit

part of the borrower surplus from its increased lending, and the total lending still decreases. This finding is consistent

with Dell'Ariccia et al. (2014), who explore how an interest rate policy by the monetary authority affects banks' deci-

sions on leverage and risk-taking, while we emphasize how the strategic interaction between a private bank and a

state-owned bank influences the effect of interest rate policy on banks' credit risks.

We then modify the basic model to consider the effect of an increase in two possible types of cost inefficiency

of the state-owned bank, which have been documented by some empirical research (Bonin et al., 2005; Cornett

et al., 2010; Fries & Taci, 2005). First, when the cost inefficiency comes from the liability side of the state-owned

bank, such as higher cost on collecting and dealing with deposits, an increase in such cost inefficiency will increase

the monitoring incentives of both banks and reduce their credit risks. This is because an increase in cost inefficiency

in the liability side induces the state-owned bank to reduce lending in order to increase its profit and to decrease

default losses from total lending, while the private bank will strategically increase its lending and thus exploit bor-

rower surplus. Since the total lending still decreases in the level of cost inefficiency under imperfect competition, the

loan rate increases in the level of cost inefficiency of the state-owned bank, inducing both banks to exert higher

levels of monitoring effort and thus lowering their credit risks.

Second, when the cost inefficiency comes from the asset side of the state-owned bank, such as higher cost on

managing assets, the state-owned bank will incur an extra management cost before monitoring.

2

Since the objective

of the state-owned bank is to maximize social welfare, it takes into account the funding cost and default losses cau-

sed by inefficiency. Therefore, on both the liability and asset sides, the effects of inefficiency of the state-owned

bank on both banks' behavior are similar, and an increase in cost inefficiency from the asset side of the state-owned-

bank raises the monitoring incentives of both banks and decreases their credit risks.

Recent studies, including La Porta et al. (2002), Sapienza (2004), Iannotta et al. (2007), Iannotta et al. (2013),

and Boubakri et al. (2020), have stressed the political view that state-owned banks will provide more financial

support to their sponsors, whose projects may not be of good quality. Accordingly, the basic model is also modi-

fied to consider that the state-owned bank puts some weight on the number of loans it makes when assessing

social welfare. We refer to the weight as the level of political view of the state-owned bank. The more the weight,

the higher level the political view. It is shown that an increase in the weight on the number of loans within the

state-owned bank induces lower monitoring incentives and higher credit risks for both banks. Since the higher

weight on the number of loans will reflect less funding cost of deposits and fewer default losses from the state-

owned bank's lending, an increase in the weight induces the state-owned bank to increase lending. The private

bank will strategically decrease lending under imperfect competition to pass through competition pressure from

the state-owned bank. However, since the total lending still increases under imperfect competition, the loan rate

decreases with the political view, which pushes both banks to lower their monitoring efforts and increase their

credit risks.

We also extend our model to discuss the effect of partial nationalization, the role of competition in a mixed oli-

gopoly, and the case of loan differentiation with price competition. In the real world, there are not only fully state-

owned banks but also partially state-owned banks active both in the developed countries such as France, Germany,

Finland, Norway, Sweden, and so forth, and in the developing countries such as Indonesia, South Korea, Taiwan, and

Thailand (La Porta et al., 2002).

3

The modification of our basic model shows that the credit risk of the partially state-

owned bank is always increasing with the level of its nationalization; however, the credit risk of the private bank dis-

plays an U-shaped association with the level of nationalization of the state-owned bank. In the case of the mixed oli-

gopoly, we find that when the level of credit market competition is more intense, both the state-owned bank and

private banks exert more effort to monitor and thus decrease their credit risks. Moreover, when the loans provided

by the private bank and the state-owned bank are differential, and they set loan rates to compete with each other,

690 TSENG AND GUO