A Macroeconomic Theory of Banking Oligopoly

We study the behavior and economic impact of oligopolistic banks in a tractable macro environment with solid micro-foundations for money and banking. Our model has three key features: (i) banks as oligopolists; (ii) liquidity constraint for banks that arises from mismatched timing of payments; and (iii) search frictions in credit, labor and goods markets. Our main ndings are: First, both bank prot and welfare react non-monotonically to the number of banks in equilibrium. Strategic interaction among banks may improve welfare as in standard Cournot competition. Nevertheless, competition among oligopolistic banks does not always improve welfare. As the number of banks rises, each bank has stronger marginal incentives to issue loans, yet each receives a smaller share of the aggregate demand deposit used to make loans. When the number is su¢ ciently high, banks become liquidity constrained in that the amount they lend is limited by the amount of deposits they can gather. In this case, welfare is dampened as banks are forced to reduce lending, which leads to fewer rms getting funded, higher unemployment, and thus ultimately lower output. Second, with entry to the banking sector, there may exist at most three equilibria of the following types: one is stable and Pareto dominates, another is unstable and ranks second in welfare, and the third is stable yet Pareto inferior. The number of banks is the lowest in the equilibrium that Pareto dominates. Finally, ination can change the nature of the equilibrium. Low ination promotes a unique good equilibrium, high ination cultivates a unique bad equilibrium, but medium ination can induce all three equilibria of the aforementioned types.