Imperfect Banking Competition and Financial Stability Jiaqi Li Bank of Canada November 2020 Disclaimer: The views expressed in this paper and presentation are those of the author and do not necessarily reflect those of the Bank of Canada.
Imperfect Bank Competition and Financial Stability • This paper studies the effects of imperfect banking competition on financial stability measured by banks’ default probabilities. 1 / 33
Imperfect Bank Competition and Financial Stability • This paper studies the effects of imperfect banking competition on financial stability measured by banks’ default probabilities. • It builds a model of bank competition focusing on bank equity ratios • Long run : less competition enhances stability higher profits → faster equity accumulation → higher equity ratios financial stability gain can outweigh macroeconomic efficiency loss ⇒ role for macroprudential regulation on banks’ dividend distribution 1 / 33
Imperfect Bank Competition and Financial Stability • This paper studies the effects of imperfect banking competition on financial stability measured by banks’ default probabilities. • It builds a model of bank competition focusing on bank equity ratios • Long run : less competition enhances stability higher profits → faster equity accumulation → higher equity ratios financial stability gain can outweigh macroeconomic efficiency loss ⇒ role for macroprudential regulation on banks’ dividend distribution • Short run : less competition can jeopardize stability due to larger size of loan assets → lower equity ratios 1 / 33
Imperfect Bank Competition and Financial Stability • This paper studies the effects of imperfect banking competition on financial stability measured by banks’ default probabilities. • It builds a model of bank competition focusing on bank equity ratios • Long run : less competition enhances stability higher profits → faster equity accumulation → higher equity ratios financial stability gain can outweigh macroeconomic efficiency loss ⇒ role for macroprudential regulation on banks’ dividend distribution • Short run : less competition can jeopardize stability due to larger size of loan assets → lower equity ratios • Empirically, this paper finds: • bank concentration (inverse proxy for competition) has a positive effect on change in bank equity • banks’ equity ratios are negatively related to their default probabilities (proxied by credit default swap spreads) 1 / 33
Imperfect Banking Competition Highly Concentrated Banking Sectors in EU and OECD Countries in 2007 and 2014 1 .8 .6 .4 .2 0 a a m a a e a s c k a d e y e y d d e l y n a a g a o s d y d a l a a a a n n d y m s i i i d l i u i r i n c n c r n n l a i i r t c d n a n i i i e i e n e e a l r u r h i t b l a n a a a v n u l g n k n a o t a a a r o a n a e a a r t p t a a x i n a w a u a a e r p d a k a t r s g i g n C o p u m l a m e g l l s I a a o M a l l o e l r d t u y p t n n e e L u b e a o r o t m v v K S r u g t s A e l u l a r C n s i r r r c r I J h M r l e P r o o w e T S u C C e e E F F e G u I m e N o o z n B B R H I t Z P S l S l h S i d A D G L i e h R t i t K t w u w e h x e d t u e o S i c L N S e n e N t U i z n C U 5-bank asset concentration ratio in 2007 5-bank asset concentration ratio in 2014 Data sources: ECB, Bankscope 5-bank asset concentration = sum of market shares of the largest 5 banks by total assets 2 / 33
Literature Review How does bank competition affect financial stability? Mixed theoretical results: • risk-taking effect: competition → lower profits → more risk taking by banks → instability (e.g. Corbae and Levine, 2018; Allen and Gale, 2000) • risk-shifting effect: competition → lower loan rate → less risk taking by borrowers → stability (e.g. Boyd and De Nicolo, 2005) • margin effect: competition → lower revenue from performing loans → less buffer against loan losses (e.g. Martinez-Miera and Repullo, 2010) ◮ This paper builds on margin effect with dynamics in bank equity 3 / 33
Literature Review How does bank competition affect financial stability? Mixed theoretical results: • risk-taking effect: competition → lower profits → more risk taking by banks → instability (e.g. Corbae and Levine, 2018; Allen and Gale, 2000) • risk-shifting effect: competition → lower loan rate → less risk taking by borrowers → stability (e.g. Boyd and De Nicolo, 2005) • margin effect: competition → lower revenue from performing loans → less buffer against loan losses (e.g. Martinez-Miera and Repullo, 2010) ◮ This paper builds on margin effect with dynamics in bank equity Mixed empirical evidence (partly depending on measures used): • competition → instability (e.g. Corbae and Levine, 2018; Ariss, 2010; Beck et al., 2006; Salas and Saurina, 2003; Keeley, 1990) • competition → stability (e.g. Anginer et al., 2014; Dick and Lehnert, 2010; Uhde and Heimeshoff, 2009; Schaeck and Cihak, 2007) • ambiguous relationship (e.g. Jimenez et al., 2013; Tabak et al, 2012) ◮ This paper provides evidence on the role of bank equity accumulation in the relationship between competition and stability 3 / 33
Main Contributions to Literature • New equity ratio effect: competition affects banks’ equity ratios and thus financial stability − Short run: less competition can jeopardize stability larger loan assets → lower banks’ equity ratios + Long run: less competition enhances stability higher profits → faster equity accumulation → higher equity ratios ⇒ important role for macroprudential policies • New measure of financial stability gain vs macroeconomic efficiency loss − without equity accumulation ⇒ efficiency loss outweighs stability gain + with equity accumulation ⇒ stability gain can outweigh efficiency loss • Empirical evidence on implications of the model: � less competition ⇒ greater profits ⇒ larger change in bank equity � banks with higher equity ratios have lower default probabilities 4 / 33
Outline • Theoretical model set-up and basic model results • Calibration and simulation results • Data • Empirical specifications • Empirical results • Conclusions 5 / 33
Model Set-up • 2 types of risk-neutral agents: • perfectly competitive entrepreneurs, short-lived, no initial wealth ⇒ borrow to finance physical capital k t (only production input) • banks compete for loans ` a la Cournot • 2 types of independent multiplicative productivity shocks (unobserved ex ante) • aggregate shock ǫ � 0, i.i.d. across time, continuous c.d.f. Γ( ǫ ), E ( ǫ ) = 1, observed by all agents ex post • idiosyncractic shock ω � 0, i.i.d. across entrepreneurs and time, continuous c.d.f. F ( ω ), E ( ω ) = 1, observed by entrepreneurs ex post (info asymmetry) • Each bank lends to a large number of randomly distributed entrepreneurs ⇒ banks can perfectly diversify idiosyncratic risk but NOT aggregate risk 6 / 33
Entrepreneur’s Default Threshold A continuum of unit mass of ex ante identical entrepreneurs borrow at a gross loan rate R b , t to finance k t Ex post, each entrepreneur i receives a different realized idiosyncratic shock ω i , t +1 and produces output: y i , t +1 = ω i , t +1 ǫ t +1 Ak α t where A is common deterministic productivity level, α ∈ (0 , 1) is capital share Entrepreneur i defaults if ω i , t +1 is below a threshold ¯ ω t +1 determined by: ω t +1 = R b , t k 1 − α t ω t +1 ǫ t +1 Ak α ¯ t − R b , t k t = 0 ¯ → ǫ t +1 A This implies: = (1 − α ) R b , t k − α ∂ ¯ ω t +1 t > 0 ∂ k t ǫ t +1 A 7 / 33
Entrepreneur’s Default Probability Entrepreneur’s default threshold ¯ ω t +1 f ( ω t +1 ) F (¯ ω t +1 ) ω t +1 ω t +1 = R b , t k 1 − α ¯ t ǫ t +1 A Higher ¯ ω t +1 → higher entrepreneur’s default probability F (¯ ω t +1 ) 8 / 33
Expected Profit Maximization Assume entrepreneurs have limited liability, • when ω i , t +1 � ¯ ω t +1 ⇒ repay full debt obligation R b , t k t • when ω i , t +1 < ¯ ω t +1 ⇒ declare bankrupt bank confiscates output (subject to a collection cost) The entrepreneur takes R b , t as given and chooses k t to maximize: �� ∞ � � ∞ ωǫ t +1 Ak α E t t dF ( ω ) − R b , t k t dF ( ω ) ω t +1 ( R b , t , k t ,ǫ t +1 ) ¯ ¯ ω t +1 ( R b , t , k t ,ǫ t +1 ) where E t [ . ] is taken over the distribution of ǫ t +1 . dk t FOC wrt k t ⇒ loan demand curve is downward-sloping: dR b , t < 0 Using optimal k t , d ¯ ω t +1 dR b , t = 0 Derivation 9 / 33
Cournot Banking Sector N Heterogeneous Banks Assumptions: • N banks (indexed by j ) with different marginal intermediation costs τ j • Loans are financed by deposits and equity n j , t (retained earnings) Bank j ’s Balance Sheet Loans k j , t Deposits k j , t − n j , t Equity n j , t • Bankers are appointed for one period ⇒ choose loan quantity k j , t to maximize expected profit E t π B j , t +1 ( ǫ t +1 ) • Full deposit insurance (presuming zero insurance premium) ⇒ exogenous gross deposit rate R t Sum of all banks’ loan quantities determines equilibrium gross loan rate R ∗ b , t 10 / 33
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