Banking Competition and Economic Stability

We consider a two-period model of a banking system to explore the effects of competition on the stability and efficiency of economic activity. In the model, competing banks lend to entrepreneurs. After entrepreneurs receive the loans for their projects, there is a probability of a shock. The shock implies that a fraction of firms will default and be unable to pay back their loans. This will require banks to use their capital and reserves to pay back depositors, restricting restrict second period lending, thus amplifying the economic effect of the initial shock. There are two possible types of equilibria, a prudent equilibrium in which banks do not collapse after the shock, and an imprudent equilibrium where banks collapse. We examine the effects of increased competition in this setting. First, we find existence conditions for prudent equilibria. Second, we showthat the effect of increased banking competition is to increase the efficiency of the economy at the expense of increased variance in second period economic results. In particular, if the probability of a shock is small, increased competition raises both expected GDP over the two period and expected activity in the second period, after the shock. Increased competition also increases the attractiveness of imprudent equilibria. Unpredicted regulatory forbearance in the aftermath of a shock can be used to reduce or eliminate the variance in economic activity. However, if regulatory forbearance is expected in response to a shock, the effect on the variance after the shock is ambiguous and can even lead to increased variance after a shock. We also show the expected result that as the size of a shock increases, there is less lending in a prudent equilibrium. Finally we show that independently of the type of equilibria or the possibility of a switch among types of equilibria, increased banking competition increases the amplification effect after a shock.