Competition and bank systemic risk: New evidence from Japan's regional banking

Bank competition and financial stability is a recurrent research issue, and researchers have begun to shed light on the effect of competition on systemic risk. In this paper, we first examine the empirical relationship between competition and systemic risk taking up the case of Japan's regional banking system. We find that competition undermines the system-wide financial stability. This result, however, sharply contrasts with those of earlier studies which utilize cross-country samples of large banking organizations. To this end, we perform a theoretical analysis focusing on the business profile of Japan's regional banks. We demonstrate that Japan's regional banks tend to diversify their portfolios toward non-core loans when the profitability of core loans declines as a result of competition. This diversification results in the build-up of systemic risk through increased common asset holdings.