Academic journal article Journal of Money, Credit & Banking

Banking Competition and Macroeconomic Performance

Academic journal article Journal of Money, Credit & Banking

Banking Competition and Macroeconomic Performance

Article excerpt

This paper uses an equilibrium model to study the costs in terms of macroeconomic performance of imperfect competition in banking. The social welfare effects of increased bank competition are complicated and ambiguous in general, but measuring the consequences of increased bank competition with standard gauges of macroeconomic performance provides a clear conclusion: Increased bank competition raises the level of income and reduces the severity of business cycles. The quantitative effect on macroeconomic performance of less competition in banking can be large; for instance, an imperfectly competitive banking system can produce a worse macroeconomic outcome than if the economy had no banks.

There is a perception that the stability of the banking industry is promoted by monopoly profits that arise from regulatory barriers to entry in banking (for example, Greenbaum and Thakor 1995). An interesting question is what the costs of such a regulatory policy are. In light of the fact that policy changes have been a major force behind a sharp increase in competition in industrial countries' banking sectors in recent years (OECD 1989), evidently policymakers currently think these costs might be large. The logic underlying these policy changes is clearly that increased banking competition improves the efficiency of the financial system which, in turn, improves macroeconomic performance. Indeed, "[t]here is a wide measure of agreement amongst the authorities of OECD countries that policies toward improving the efficiency and the functioning of financial systems should essentially be implemented through competition policies aiming at increasing the scope for adequate price competition, product, and service competition and territorial competition" (OECD (1989, p. 79)). Thus, in the European Community (EC) for example, the Second Banking Coordination Directive (2BCD) "paves the way to an increase in the level of banking competition and the associated welfare gains" (Vesala (1993, p. 5)).(1)

If restricting competition in the banking industry imposes costs in terms of macroeconomic performance, the question arises as to whether these costs derive from a lower level of income, more severe business cycles, or both. This paper seeks to shed light on this question in a general equilibrium model in which financial intermediaries arise endogenously. There have been several studies of bank competition, but they are different from this paper because they are typically partial-equilibrium studies that focus on specific issues in banking rather than macroeconomic performance.(2) The most important general conclusion of the paper is that a more competitive banking system increases the level of macroeconomic activity and reduces the severity of business cycles. Numerical exercises presented below suggest that imperfect competition in banking can have much more important consequences for macroeconomic performance than imperfect information in credit markets (which is the key reason in the model that banks exist).

The intuition for these findings is as follows. If banks are competitive, then the lower agency costs associated with intermediated financing benefit individual borrowers in that the total cost of external funds falls by the amount of the reduction in agency costs that banks are responsible for. When banks have market power, however, it is generally in a bank's interest to capture through loan rates the reduction in agency costs that the bank is able to generate. There is, in addition, a potentially important general equilibrium effect of this loan-pricing behavior of imperfectly competitive banks: Banks profitability feeds directly into the return on bank liabilities, which in turn works to raise the opportunity cost of funds in the economy, and thus further raises the cost of external financing. This implies that when banks have market power, even highly creditworthy firms (that are not bank dependent) may face a higher cost of financing, both in decentralized loan markets and in the market for bank loans. …

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