How Banking Competition Affects Economic Growth and Welfare

Abstract

Competition is commonly praised by economists: it causes low prices, efficient outcomes, and high levels of welfare. This article challenges this view by exploring the effect of interbank competition on economic growth and welfare in a dynamic model with endogenous capital accumulation. It demonstrates that monopolistic banking outperforms its competitive counterpart in terms of both growth and welfare if the production technology is capital-intensive, whereas competition is favorable for labor-intensive technologies. The model can thereby explain an empirical puzzle. Irrespective of competition, banks increase an economy's level of long-run growth by encouraging investments of private households through the provision of risk sharing. A banking monopoly can induce endogenous growth cycles if profits are redistributed to agents as dividends.

Keywords: Financial Intermediation, Economic Growth, Welfare, Endogenous Fluctuations, OLG Models, Deposit Contracts, Risk Sharing

JEL Classification: D53, E32, E44, G21, O41