This essay is based on the working paper “Competition, Stability, and Efficiency in the Banking Industry” by Dean Corbae and Ross Levine.

How do government policies affect bank stability and efficiency? For example, do policies that make it easier for banks to compete with one another involve a tradeoff, with competition boosting bank efficiency but simultaneously encouraging banks to take excessive risks? Can policies that reduce the traditional corporate governance tensions between bank shareholders and managers lessen any tradeoff between efficiency and stability triggered by competition? How do regulations that reduce bank leverage—the debt-to-equity ratio—affect bank competition, efficiency, and stability? What is the impact of monetary policy on the risks that banks take and the efficiency with which they operate?

We undertake two coordinated research strategies to address these core policy questions. First, we build a mathematical model that yields predictions about the impact of a wide range of policies on bank efficiency and stability. This toolkit, which we make available to others, allows policy analysts to answer questions such as: What are the effects on efficiency and stability of choosing one suite of policies relative to an alternative group of policies? Given political economy constraints on the feasibility of regulatory reforms, which policies will best foster a safe, efficient banking system? How can monetary policy complement regulatory policies to achieve efficiency and stability? While our model can be applied to many countries, we fit the model to the US banking industry. That is, we use data about the structure of the US banking industry to “parameterize” the model so that the model captures essential features of the US economy.

Second, we test several of the model’s central predictions about the impact of policies on bank efficiency and stability. In particular, the model predicts how competition policies, governance policies, capital regulations, and monetary policy combine to influence the banking industry. Using US data, we test how these policies affect stability, as captured by banks’ stock price variations, and market efficiency, as captured by banks’ charter values.

Before summarizing key findings, we describe the critical building blocks of our mathematical model. In our model, banks compete for insured deposits and make risky loans. Loans with higher returns have higher risk. Consistent with traditional governance tensions, bank managers and shareholders disagree about how many deposits to raise and how risky the bank’s loans should be. Managers care more about short-run profits than shareholders, pushing them to borrow more and take more risks than shareholders would like. The combination of limited liability and government-provided deposit insurance creates moral hazard, i.e., it incentivizes bankers to make riskier loans than they otherwise would. In addition, banks impose externalities on one another. When one bank expands, this bids up interest rates on deposits and induces banks to make riskier loans to generate the returns necessary to pay those higher borrowing costs. Another key feature of our model is that we consider the impact of policies on banking systems in the short run and the long run. The core difference is that in the long run, new banks can enter and old banks exit depending on the banking industry's profitability.

What do we find after simulating the model and empirically testing its predictions?

First, intensifying bank competition involves an efficiency–stability tradeoff. Intensifying bank competition squeezes bank profits and pushes managers to reach for yield by taking on riskier projects and overlending.

Second, there are extensive, economy-wide benefits to regulations that improve bank governance, i.e., regulations that induce bank managers to behave more in the long-run interests of the bank’s shareholders. Regulations that enhance governance (1) reduce excessive bank risk-taking; (2) ease the efficiency–stability tradeoff from intensifying competition, meaning society can get the efficiency benefits from competition while easing the adverse risk effects; and (3) allow regulators to achieve a given improvement in banking system stability with a smaller tightening of capital requirements.

Third, monetary policy's economic impact depends critically on bank regulation. For example, contractionary monetary policy increases instability less when banking markets are more competitive. Thus, policies shaping the competitiveness of the banking industry, including lowering regulatory barriers to the entry of new banks or fintech firms, can alter the impact of monetary policy on the economy.

Our analyses highlight and stress the central point raised in the conference’s keynote address by Nobel laureate Doug Diamond, that using accounting-based measures of bank capital rather than market-based measures can have enormous adverse consequences. Specifically, our analyses show that accounting-based measures, which focus on historical book values, exacerbate the excessive risk-taking incentives triggered by contractionary monetary policy by making the bank appear less risky. Our analyses capture recent experiences at SVB and First Republic.   

In summary, we create and use a toolkit for assessing the impact of policies on the banking industry. Although we focus on the effects of capital regulations, governance policies, competition policies, and monetary policy, we also use the model to explore the effects of too-big-to-fail policies, the rise of shadow banking, and the impact of financial technology on bank efficiency and stability.

Read the full paper here.

Dean Corbae is the William Sellery Trukenbrod Chair in Finance and a professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business. Ross Levine is a senior fellow at the Hoover Institution, Stanford University, and co-director of its Working Group on Financial Regulation.

This essay is part of the Financial Regulation Research Brief Series. Research briefs highlight the policy-relevant features of research on financial systems, including the impact of financial regulations on economic growth, stability, and other factors shaping living standards.

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