Bank profits, risk, and local market concentration

Abstract

A simultaneous equation system of bank profits and bank risk is specified to examine the relationship between profits and risk and to test whether the estimated effect of market concentration on bank profits is biased when risk is ignored. Bank risk, measured by the standard deviation of profits, can be attributed to exogeneos local market uncertainty and endogenous risk-taking behavior. The empirical results show that bank risk reduces bank profits because a bank that maximizes expected profits recognizes expected costs, such as higher premiums on uninsured deposits demanded by risk-averse investors, that are associated with high risk. Furthermore, the effect of market concentration on bank profits becomes larger once risk is included, although the effect remains quantitatively small.