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 a large bank-level panel from EU and OECD countries spanning around 15 years. 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 global financial crisis, there has been an increasing focus on incorporating financial frictions into a dynamic stochastic general equilibrium (DSGE) model, often by introducing an 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 that features an 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 aggregate fluctuations.
While it is widely perceived that financial frictions have adverse impact on capital allocation, the importance of this impact is difficult to quantify. This paper presents a novel two-step approach to estimate the importance of financial frictions on capital misallocation, measured by the dispersion of the marginal revenue product of capital. First, based on the general theoretical result that the capital investment of financially constrained firms is more sensitive to their internal financing than for unconstrained firms, I use a switching regression approach to jointly estimate the two different investment regimes and the probability of each firm being constrained. Firms are classified as financially constrained or unconstrained based on the estimated probabilities. Second, I provide a decomposition of capital misallocation and estimate the fraction that can be explained by the presence of financially constrained firms. Applying this method to large panels of manufacturing firms for 20 countries from the 1990s to 2015, this paper finds that for most countries and two-digit industries, more than a quarter of firms are classified as financially constrained. Furthermore, the presence of these constrained firms accounts for more than half of capital misallocation.