Competition, Stability, and Efficiency in the Banking Industry

Abstract: We provide a tractable dynamic model of the banking industry where (1) an intensification of competition increases market measures of efficiency and fragility of banks but not necessarily social measures of efficiency; (2) economies can avoid the fragility costs of competition by enhancing bank governance and tightening leverage requirements; and (3) bank competition materially shapes risk taking and the monetary transmission mechanism. Using detailed data on U.S. banks, we find statistical evidence supportive of the model predictions. In a series of experiments, we show how the model can be used to make predictions about the impact of too-big-to-fail, regulatory arbitrage, the impact of changes in financial technology, and contagion/runs on risk taking and competition.

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