The Digital Banking Revolution: Effects on Competition and Stability

Abstract

How does the digital revolution affect bank competition and financial stability? I use hand-collected data and a novel identification strategy to show that after adopting digital platforms, banks branchlessly operate in more markets, and mid-size banks — those with relatively high quality digital platforms but without extensive branch networks — grow faster. Further, bank balance sheet composition tilts to uninsured deposits on the funding side, and to high income borrowers on the loan side. To disentangle the underlying mechanisms and quantify aggregate effects, I build a structural model of the U.S. banking system and compare the observed digital equilibrium to a counterfactual without digital platforms. The model allows for endogenous adoption of digital platforms, branch networks, market entry, and accounts for digitalization among non-banks. Digitalization decreases local and national market concentration, and average markups fall in deposit and loan markets, holding fixed the size of the banking sector. Consumers capture most of the surplus created by digitalization, however it accrues mostly to wealthier segments of the economy. As for stability, it increases the average market share of lightly-regulated mid-sized banks by 29%, increases the uninsured deposits ratio of the banking sector by 9% while re-sorting uninsured deposits towards larger digital banks, and doubles credit risks associated with lending in market segments that are less-well served by digital technologies. In sum, digital banking increases competition and poses risks to financial stability.

Keywords: digital banking, financial stability, bank competition, technological innovation, digitalization

JEL Classification: G21, L1, O33