We model the relationship between market power and both loan interest rates and211u001ebank risk without placing strong restrictions on the moral hazard problems 211u001ebetween borrowers and banks, and between banks and a government guarantor. Our 211u001eresults suggest that these relationships hinge on intuitive parameterizations of 211u001ethe overlapping moral hazard problems. Surprisingly, for lending markets with a 211u001ehigh degree of borrower moral hazard, but limited bank moral hazard, we find that 211u001ebanks with market power charge lower interest rates than competitive banks. We 211u001ealso find that competition makes banking industry risk highly sensitive to 211u001emacroeconomic fluctuations by making banks more vulnerable to borrower moral 211u001ehazard. This finding offers an explanation for the dramatic rise and subsequent 211u001edecline in bank failure rates during the 1980s and 1990s.
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