Universal banking, competition and risk in a macro model

A stylized macroeconomic model is developed with an indebted, heterogeneous Investment Banking Sector funded by borrowing from a retail banking sector. The government guarantees retail deposits. Investment banks choose how risky their activities should be. We find that the financial sector can move very sharply from safe to risky investment strategies and that the degree of competitiveness is important for risk premia. We also compared the benefits of separated vs. universal banking modelled as a vertical integration of the retail and investment banks. The incidence of banking default is considered under different constellations of shocks and degrees of competitiveness. The benefits of universal banking rise in the volatility of idiosyncratic shocks to trading strategies and are positive even for very bad common shocks, even though government bailouts, which are costly, are larger compared to the case of separated banking entities. The benefits of universal banking are positive but decreasing in the value and volatility of shocks to the quality of financial capital. When shock is moderate, competition improves the welfare. However, banks with some market power have a cushion of profits against adverse shocks which is beneficial since there is an excess burden associated with government bailouts. Hence, when a worse shock hits the economy, the optimal degree of competitiveness of separate banking firms is higher than for universal firms. So, the welfare assessment of the structure of banks may depend crucially on the kinds of shock hitting the economy as well as on the efficiency of government intervention.