Academic journal article Federal Reserve Bank of New York Economic Policy Review

Trends in Financial Market Concentration and Their Implications for Market Stability

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Trends in Financial Market Concentration and Their Implications for Market Stability

Article excerpt

* The issue of whether concentrated financial markets-those with a few large suppliers- are more stable or less stable than less concentrated markets is important to policymakers and others concerned about potential market disruptions.

* An analysis of how U.S. financial market structure has changed over the last decade finds no pervasive pattern of high and increasing concentration.

* A complementary line of inquiry into the link between concentration and the risk or severity of market instability focuses on substitution by firms; substitution can stabilize markets by dampening the upward pressure on prices attributable to a large exiting supplier.

* The departure of a major supplier will cause less market disruption the more promptly other firms can substitute for it.

1. INTRODUCTION

Imagine two very different financial market structures. The first has many suppliers, each with only a small share of the market. The second has a few very large firms that supply most of the market, plus many smaller players that make up the rest. Which structure is more stable: the one with many small firms or the concentrated market where a few firms dominate? Which structure best describes financial markets in the United States? Those are questions we address in this article.1

A stable market is one that can endure shocks to supply or demand without collapsing-that is, without experiencing surging (or wildly oscillating) prices or sharply shrinking volumes. Stability requires certain self-correcting tendencies that ensure that a market can right itself. If supply falls because a major producer fails, for example, the resulting excess demand must push prices upward. Rising prices, in turn, must induce prompt substitution toward other suppliers or products. Substitution tends to dampen upward pressure on prices, thus stabilizing the market.

Markets can experience shocks to supply or demand from many sources, such as changes in regulation, technological innovation, shifts in demographics, and knock-on effects from shocks to other markets or economic sectors. We focus here primarily on one particular type of supply shock: the failure and exit of one or more large suppliers. This is a natural channel to focus on given our interest in the relationship between market concentration and market stability, since the presence of a few large suppliers is the defining feature of a concentrated market.

The link between concentration and stability is hard to pin down, so we mostly try to identify the link by breaking it down into parts. For example, we distinguish between the probability of distress by a given firm and the severity of the market consequences in that event. After reviewing literature that investigates the link between financial market concentration and financial stability, we conclude that the link is ambiguous- some of the side effects of changing market structure may have a stabilizing influence, while other influences may be destabilizing. Our own findings are consistent with that ambiguity. We find a mixed relationship between market concentration and volatility in the investment-grade-bond and syndicated loan markets, consistent with an ambiguous relationship as suggested in the theoretical literature. We conclude that there are no simple answers to the question of whether concentrated financial markets are more stable or less stable than less concentrated markets.

Our analysis of how U.S. financial market structure has changed over the last decade produces more definitive conclusions. Using firm-level data from a variety of sources, including data collected by central banks, we document that in aggregate, most U.S. wholesale credit and capital markets are only moderately concentrated. Concentration in most global over-the-counter (OTC) derivatives markets is low, though rising. Overall, concentration trends are mixed, rising in some markets and falling in others. …

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