The Effect of Credit Competition on Banks’ Loan-Loss Provisions

Abstract

Exploiting differential interstate-branching deregulation across contiguous counties of adjacent states, we investigate the effect of entry threat on incumbent banks’ loan-loss provisions. Incumbents exposed to entry threat have offsetting incentives; lower provisions make their loan-underwriting quality appear better, deterring entry, but make local economic conditions appear better, encouraging entry. We find that the incentive to increase apparent loan-underwriting quality dominates on average. We further find that this incentive is stronger in counties with a higher proportion of heterogeneous loans, while the other incentive dominates in counties with both low heterogeneous loans and highly volatile economic conditions.