The Effect of Credit Competition on Banks’ Loan Loss Provisions

Yiwei Dou, Stephen G. Ryan, and Youli Zou

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, while 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, and that the other incentive dominates in counties with both few heterogeneous loans and highly volatile economic conditions.