Does bank competition jeopardize financial stability? By building a model of imperfect banking competition featuring the accumulation of bank equity via retained earnings, this paper finds that bank competition can have different short-run and long-run effects on financial stability. In the short run, less competition can jeopardize stability as it increases banks’ loan assets and thus lowers their equity-to-assets ratios (equity ratios), making them more likely to default. In the long run, less competition tends to enhance stability as banks make higher profits and accumulate equity faster over time, resulting in higher equity ratios and hence lower bank default probabilities. The extent of this long-run stability gain from less competition and whether the stability gain outweighs the efficiency loss crucially depend on banks’ dividend distribution or macroprudential policies. Empirically, this paper finds two sets of supporting evidence for the model predictions using bank-level data from EU and OECD countries. First, bank concentration, an inverse measure for competition, has a significant positive effect on the change in bank equity. Second, banks’ equity ratios are found to be negatively related to their default probabilities, which are proxied by credit default swap spreads.
Following the recent financial crisis, there has been an increasing focus on incorporating financial frictions into a dynamic stochastic general equilibrium (DSGE) model, often by introducing the agency problem which serves to amplify macroeconomic shocks. This paper examines the impact of another important financial friction, imperfect competition in banking, on aggregate fluctuations by incorporating a Cournot banking sector into a DSGE model embedded with the agency problem that gives rise to collateral constraints. In the presence of a binding collateral constraint, imperfect banking competition is found to have an amplification effect on aggregate fluctuations after a contractionary monetary policy shock and adverse collateral shocks. Adverse shocks that make borrowers more financially constrained and their loan demand more inelastic can induce banks with market power to raise the loan rate, resulting in a countercyclical loan interest margin that amplifies the aggregate fluctuations.