Finance as a Barrier to Entry: U.S. Bank Deregulation and Business Cycle

Abstract

This paper studies the effects of financial deregulation that reduces monopoly power of financial intermediaries, in a dynamic, stochastic, general equilibrium model with endogenous producer entry subject to sunk cost. I show that deregulation results in an expansion in the number of producers, a decrease in producer size, an increase in output share of financial intermediaries and in an increase in size of the economy. Less monopoly power in financial intermediation results in less volatile producer entry, reduced producer markup countercyclicality, and weaker substitution effects in labor supply in response to aggregate productivity shocks. Deregulation thus contributes to a moderation of firm-level and aggregate output volatility. The results of the model are consistent with features of U.S. data following the period of dramatic bank deregulation between the late 1970s and the mid 1990s.