Last bank standing : what do I gain if you fail?

Banks attitude towards speculative lending is typically regarded as the result of trading-off the short-term gains from risk-taking against the risk of loss of charter value. We study the trade-off between stability and competition in a dynamic setting where charter value depends on future market competition. Promoting the takeover of failed banks by solvent institutions results in greater market concentration and larger rents for the surviving incumbents. This converts banks' speculative lending decisions into strategic substitutes, granting an additional incentive to remain solvent. Entry policy may subsequently serve to fine-tune the trade-off between competition and stability. (c) 2002 Elsevier Science B.V.All rights reserved.