Working Paper: CEPR ID: DP10121
Authors: Xavier Freixas; Kebin Ma
Abstract: This paper reexamines the classical issue of the possible trade-o s between banking competition and financial stability by highlighting different types of risk and the role of leverage. By means of a simple model we show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on banks' liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts, and on whether the indebtness is exogenous or endogenous. In particular we suggest that, while in a classical originate-to-hold banking industry competition might increase financial stability, the opposite can be true for an originate-to-distribute banking industry of a larger fraction of market short-term funding. This leads us to revisit the existing empirical literature using a more precise classification of risk. Our theoretical model therefore helps to clarify a number of apparently contradictory empirical results and proposes new ways to analyze the impact of banking competition on financial stability.
Keywords: banking competition; financial stability; leverage
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Competition (L13) | Portfolio Risk (G11) |
| Competition (L13) | Insolvency Risk (G33) |
| Competition (L13) | Liquidity Risk (G33) |
| Competition (L13) | Systemic Risk (E44) |
| Type of Banking Structure (G21) | Financial Stability (G28) |
| Competition (L13) | Loan Default Risk (G33) |
| Competition (L13) | Entrepreneurs' Moral Hazard (L26) |
| Competition (L13) | Bank Profits (G21) |
| Bank Profits (G21) | Loan Losses (G33) |
| Leverage Endogeneity (C51) | Liquidity Risk (G33) |
| Competition (L13) | Total Credit Risk (G32) |
| Competition (L13) | Probability of Solvent but Illiquid Bank (G33) |