Banking Competition and Stability: The Role of Leverage

X. Freixas, K. Ma

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    Abstract

    This paper reexamines the classical issue of the possible trade-offs between banking competition and financial stability by highlighting different types of risk and the role of leverage. By means of a simple model we show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on banks’ liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts, and on whether the indebtness is exogenous or endogenous. In particular we suggest that, while in a classical originate-to-hold banking industry competition might increase financial stability, the opposite can be true for an originate-to-distribute banking industry of a larger fraction of market short-term funding. This leads us to revisit the existing empirical literature using a more precise classification of risk. Our theoretical model therefore helps to clarify a number of apparently contradictory empirical results and proposes new ways to analyze the impact of banking competition on financial stability.
    Original languageEnglish
    Place of PublicationTilburg
    PublisherEconomics
    Pages1-41
    Number of pages41
    Volume2014-048
    Publication statusPublished - 29 Aug 2014

    Publication series

    NameCentER Discussion Paper
    Volume2014-048

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    Keywords

    • Banking Competition
    • Financial Stability
    • Leverage

    Cite this

    Freixas, X., & Ma, K. (2014). Banking Competition and Stability: The Role of Leverage. (pp. 1-41). (CentER Discussion Paper ; Vol. 2014-048). Economics.