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Banking Competition and Economic Stability

  • Ronald Fischer
  • Nicolás Inostroza
  • Felipe J. Ramírez

    ()

We consider a two-period model of a banking system to explore the effects of competition on the stability and efficiency of economic activity. In the model, competing banks lend to entrepreneurs. After entrepreneurs receive the loans for their projects, there is a probability of a shock. The shock implies that a fraction of firms will default and be unable to pay back their loans. This will require banks to use their capital and reserves to pay back depositors, restricting restrict second period lending, thus amplifying the economic effect of the initial shock. There are two possible types of equilibria, a prudent equilibrium in which banks do not collapse after the shock, and an imprudent equilibrium where banks collapse. We examine the effects of increased competition in this setting. First, we find existence conditions for prudent equilibria. Second, we showthat the effect of increased banking competition is to increase the efficiency of the economy at the expense of increased variance in second period economic results. In particular, if the probability of a shock is small, increased competition raises both expected GDP over the two period and expected activity in the second period, after the shock. Increased competition also increases the attractiveness of imprudent equilibria. Unpredicted regulatory forbearance in the aftermath of a shock can be used to reduce or eliminate the variance in economic activity. However, if regulatory forbearance is expected in response to a shock, the effect on the variance after the shock is ambiguous and can even lead to increased variance after a shock. We also show the expected result that as the size of a shock increases, there is less lending in a prudent equilibrium. Finally we show that independently of the type of equilibria or the possibility of a switch among types of equilibria, increased banking competition increases the amplification effect after a shock.

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File URL: http://www.dii.uchile.cl/~cea/sitedev/cea/www/download.php?file=documentos_trabajo/ASOCFILE120130703152450.pdf
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Paper provided by Centro de Economía Aplicada, Universidad de Chile in its series Documentos de Trabajo with number 296.

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Date of creation: 2013
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Handle: RePEc:edj:ceauch:296
Contact details of provider: Web page: http://www.dii.uchile.cl/cea/

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  1. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  2. Xavier Vives, 2011. "Competition and Stability in Banking," Central Banking, Analysis, and Economic Policies Book Series, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.), Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 12, pages 455-502 Central Bank of Chile.
  3. Martinez-Miera, David & Repullo, Rafael, 2008. "Does Competition Reduce the Risk of Bank Failure?," CEPR Discussion Papers 6669, C.E.P.R. Discussion Papers.
  4. Anginer, Deniz & Demirguc-Kunt, Asli & Zhu, Min, 2012. "How does bank competition affect systemic stability ?," Policy Research Working Paper Series 5981, The World Bank.
  5. Sharpe, Steven A, 1990. " Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships," Journal of Finance, American Finance Association, vol. 45(4), pages 1069-87, September.
  6. Rafael Repullo, 2002. "Capital requirements, market power, and risk-taking in banking," Proceedings 809, Federal Reserve Bank of Chicago.
  7. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  8. Beck, Thorsten & De Jonghe, Olivier & Schepens, Glenn, 2013. "Bank competition and stability: Cross-country heterogeneity," Journal of Financial Intermediation, Elsevier, vol. 22(2), pages 218-244.
  9. Berger, Philip G. & Ofek, Eli, 1995. "Diversification's effect on firm value," Journal of Financial Economics, Elsevier, vol. 37(1), pages 39-65, January.
  10. Dixit, Avinash K, 1986. "Comparative Statics for Oligopoly," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 27(1), pages 107-22, February.
  11. Allen, Franklin & Gale, Douglas, 2004. "Competition and Financial Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 453-80, June.
  12. Hakenes, Hendrik & Schnabel, Isabel, 2011. "Capital regulation, bank competition, and financial stability," Economics Letters, Elsevier, vol. 113(3), pages 256-258.
  13. Klaus Schaeck & Martin Cihak & Simon Wolfe, 2009. "Are Competitive Banking Systems More Stable?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 711-734, 06.
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