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Allen N. Berger and Gregory F. Udell

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Allen N. Berger and Raluca A. Roman

Is finance an important driver for the development and growth of the real economy in the United States or is it rather a negative rent-seeking force that impedes growth and prosperity? Most academics believe that finance boosts the economy, while society often has a very different view. This chapter reviews the academic research on the issue, contributes to the debate, and demonstrates that for the most part, at the margin, finance has a positive effect on the US economy. In most but not all cases, exogenous or instrumentable events demonstrate that private debt, public debt, private equity, and public equity contribute favorably to real economic outcomes in the United States. The evidence also suggests some conclusions about regulation and provides some future research avenues.

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Allen N. Berger, Leora F. Klapper and Rima Turk-Ariss

Under the traditional “competition–fragility” view, more bank competition erodes market power, decreases profit margins, and results in reduced franchise value that encourages bank risk taking. Under the alternative “competition–stability” view, more market power in the loan market may result in higher bank risk, as the higher interest rates charged to loan customers make it harder to repay loans, and exacerbate moral hazard and adverse selection problems. The two strands of the literature need not necessarily yield opposing predictions regarding the effects of competition and market power on stability in banking. Even if market power in the loan market results in riskier loan portfolios, the overall risks of banks need not increase if banks protect their franchise values by increasing their equity capital or engaging in other risk-mitigating techniques. The authors test these theories by regressing measures of loan risk, bank risk, and bank equity capital on several measures of market power, as well as indicators of the business environment, using data for 8235 banks in 23 developed nations. The results suggest that – consistent with the traditional “competition–fragility” view – banks with a higher degree of market power also have less overall risk exposure. The data also provide some support for one element of the “competition–stability” view – that market power increases loan portfolio risk. The authors show that this risk may be offset in part by higher equity capital ratios.