Xavier Freixas, Kebin Ma (August 20, 2014). “Banking Competition and Stability: The Role of Leverage”
It has been often argued that competition in the banking industry is a double edge sword: while it may increase efficiency, it may also foster financial instability and trigger financial crises. Still, there is no agreement either on the right theoretical model nor on the adequate empirical approach. This is why our paper reexamines the classical issue of the possible trade-offs between banking competition and financial stability by highlighting different types of risk and the role of leverage that was neglected in previous analysis. 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.
Xavier Freixas is an Economics graduate and holds a PhD in Economics from the University of Toulouse (1978). He is currently the Head of Department of Economics and Business at Pompeu Fabra University and a financial economics professor and director of the Master of Science in Finance and Banking programme and the Master in Financial Markets programme at the UPF Barcelona School of Management.