Financial Frictions, Bank Efficiency and Risk: Evidence from the Eurozone

<jats:p><jats:bold>Abstract: </jats:bold> This paper employs a simultaneous equations approach to investigate the dynamics between financial frictions, efficiency and risk for eurozone's commercial banks. We consider two related channels through which financial frictions may arise: informational and market structure imperfections, and allow for a possible reverse causation from efficiency to banks’ asset quality. The findings validate the presence of both channels of financial frictions and are consistent with the efficiency‐lending quality hypothesis that low efficiency signals poor asset quality loans. Finally, our findings suggest that policies aimed at constraining banks’ degree of openness may ultimately direct management choices towards riskier investments.</jats:p>