Banking Competition, Increasing Returns to Scale, and Financial Fragility

Abstract

How do liquidity creation and financial fragility depend on the dual effects of increasing returns to scale and banking competition? We study this question in a model of financial intermediation with limited commitment. In the absence of scale economies, the degree of fragility is independent of the amount of bank investment and the scope for instability of a monopolistic bank is strictly contained in that of its competitive counterpart. Yet, when the minimum scale effect is present, the conventional results may be overturned. In particular, the competitive bank facing an intermediate scale threshold for the high asset return is able to deliver the highest welfare to depositors but is most prone to panics when runs are highly unlikely. That is, due to increasing returns in normal times, the intermediary behaves aggressively by providing high payments in the short-term but only low output will be realized should run behavior emerge. In contrast, the monopolistic bank that engages in rent-seeking, strategic behavior is most susceptible to runs if both the minimum scale requirement and the propensity to panic are sufficiently high. To be specific, the potential failure to qualify for increasing returns tightens depositors’ participation constraints, especially in a more crisis-prone economy. Thus, if the bank fails to earn high returns on its assets and the prospect of a run is high, it must augment payoffs on early demandable deposits, leaving itself excessively illiquid and unstable. In addition, there exist economies where the competitive bank is better for stability than the monopolist as relative fragility depends on respective minimum scales facing banks.