Failed bank takeovers and financial stability

•There are 2 banks deciding risk taking in an infinite horizon model.•If one of the banks fails a supervisor may allow the surviving bank to takeover the failed competitor or to allow a new bank entering the market.•Systemic failures trigger bank bail outs.•Allowing the takeover may give duopolist banks an incentive to prudently invest (a result already pointed out by previous literature, e.g. Perotti and Suarez, 2002 and Acharya and Yorulmazer, 2007). Once the takeover occurred, the resulting bank chooses excessive risk taking, which increases the likelihood of future systemic failures.•When bankers are impatient (they have high discount rates) the negative effect offsets the positive one.

Current discussion about the design of bank resolution frameworks suggests that the takeover of a failed bank by an incumbent one has two effects on financial stability. First, the incumbent takeover may boost financial stability by providing bankers with incentives to be solvent so as to profit from their competitors’ failure. Second, the incumbent takeover may spoil financial stability by creating “Systemically Important Financial Institutions”. The innovation of this paper is to capture these two effects in a theoretical model. We show that when incumbent bankers are impatient enough (i.e., they have high discount rates), the second effect prevails over the first one. We discuss the implications of this result for the design of bank resolution policies.