Business Cycles and the Role of Imperfect Competition in the Banking System*

Abstract

This study shows that the entry of new competitors in the banking system tends to occur during economic expansions. In addition, it provides evidence that established banks react by lowering the interest rates that borrowers pay, thus reducing bank system profits. In contrast, banks are able to sustain higher bank profit margins during recessions. These findings suggest that this pricing strategy is aimed at deterring the entry of new bank competitors into highly segmented regional retail niches. Consequently, monopolistic banking not only creates an inefficient wedge between lenders and borrowers but, as credit becomes cheaper in booms and more expensive during recessions, it further contributes to macroeconomic volatility. Empirical evidence for 124 countries and a general equilibrium model suitable to quantify the welfare losses of this monopolistic framework are provided.