Banking Competition and Economic Stability
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.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- 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.
- Diamond, Douglas W & Dybvig, Philip H, 1983.
"Bank Runs, Deposit Insurance, and Liquidity,"
Journal of Political Economy,
University of Chicago Press, vol. 91(3), pages 401-19, June.
- Jean Tirole, 2006. "The Theory of Corporate Finance," Post-Print hal-00173191, HAL.
- 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.
- Steven A. Sharpe, 1989. "Asymmetric information, bank lending, and implicit contracts: a stylized model of customer relationships," Finance and Economics Discussion Series 70, Board of Governors of the Federal Reserve System (U.S.).
- Rafael Repullo, 2002.
"Capital requirements, market power, and risk-taking in banking,"
809, Federal Reserve Bank of Chicago.
- Repullo, Rafael, 2004. "Capital requirements, market power, and risk-taking in banking," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 156-182, April.
- Repullo, Rafael, 2003. "Capital Requirements, Market Power and Risk-Taking in Banking," CEPR Discussion Papers 3721, C.E.P.R. Discussion Papers.
- Hakenes, Hendrik & Schnabel, Isabel, 2011. "Capital regulation, bank competition, and financial stability," Economics Letters, Elsevier, vol. 113(3), pages 256-258.
- David Martinez-Miera & Rafael Repullo, 2010.
"Does Competition Reduce the Risk of Bank Failure?,"
Review of Financial Studies,
Society for Financial Studies, vol. 23(10), pages 3638-3664, October.
- T. Beck & O. De Jonghe & G. Schepens, 2011.
"Bank competition and stability: cross-country heterogeneity,"
Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium
11/732, Ghent University, Faculty of Economics and Business Administration.
- 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.
- 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.
- Xavier Vives, 2010. "Competition and Stability in Banking," CESifo Working Paper Series 3050, CESifo Group Munich.
- Xavier Vives, 2010. "Competition and Stability in Banking," Working Papers Central Bank of Chile 576, Central Bank of Chile.
- Vives, Xavier, 2010. "Competition and stability in banking," IESE Research Papers D/852, IESE Business School.
- 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.
- Berger, Philip G. & Ofek, Eli, 1995. "Diversification's effect on firm value," Journal of Financial Economics, Elsevier, vol. 37(1), pages 39-65, January.
- Anginer, Deniz & Demirguc-Kunt, Asli & Zhu, Min, 2012. "How does bank competition affect systemic stability ?," Policy Research Working Paper Series 5981, The World Bank.
- Allen, Franklin & Gale, Douglas, 2004.
"Competition and Financial Stability,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 36(3), pages 453-80, June.
When requesting a correction, please mention this item's handle: RePEc:edj:ceauch:296. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.