Financial Intermediation, Competition, and Risk: A General Equilibrium Exposition
CentER Discussion Paper Series No. 2010-67S
31 Pages Posted: 7 Jul 2010
Date Written: May 31, 2009
We study a simple general equilibrium model in which investment in a risky technology is subject to moral hazard and banks can extract market power rents. We show that more bank competition results in lower economy-wide risk, lower bank capital ratios, more efficient production plans and Pareto-ranked real allocations. Perfect competition supports a second best allocation and optimal levels of bank risk and capitalization. These results are at variance with those obtained by a large literature that has studied a similar environment in partial equilibrium. Importantly, they are empirically relevant, and demonstrate the need of general equilibrium modeling to design financial policies aimed at attaining socially optimal levels of systemic risk in the economy.
Keywords: General Equilibrium, Bank Competition, Market Power Rents, Risk
JEL Classification: D5, G21
Suggested Citation: Suggested Citation