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Competition And Risk Taking Incentives In The Lending Market: An Application To Indian Banking

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Executive Summary

This paper develops a structural model of competition in the lending market to examine the impact of financial reforms both on competition and on banks' risk taking incentives. Drawing on the literature on the uniqueness of bank loans vis-?-vis arms length debt, this paper estimates an empirical model with reference to the Indian commercial banking reform experience (1992-2004). Our results suggest an increase in competition along with the reform process. The analysis of banks' risk taking incentives, however, fails to detect the existence of a market-based mechanism to support lenders' information acquisition. Banks with lower monitoring and screening capacity appear to be preferred by borrowers when the market becomes more competitive, thus implying an increase in banks' risk taking incentives along with the increase in competition.

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