State aid and competition in banking: the case of China in the late nineties

Many contributions to the literature on competition in banking use the Panzar and
Rosse test (1987). This test encompasses a variety of market outcomes assuming firms
maximize profits. However, when applied to the banking industry, this assumption
may not be always valid as banks sometimes may carry social objectives or aim to be
systemic players so as to be "too big to fail". This then motivates different objective
functions, departing from profit maximization. We present a reduced form model
where banks can pursue other goals than profit maximization. This allows us to test
for behavioral changes of banks over time. Our model provides a framework to
evaluate whether moral hazard issues may plague banks receiving state aid, which
concerns greatly the recent debate on government intervention in financial markets
during the global financial crisis in 2008. To test the impact of state aid, we examine a
natural experiment in the banking sector in China in the 1990s. We cannot reject that
the possibility of receiving state aid triggers moral hazard prone conduct.