Ebook Banking Competition, Credit Market Activity, and the Effects of Monetary Policy
Numerous research demonstrates that banks provide valuable economic functions in financial markets. One significant factor that affects financial market activity is the degree of competition. Notably, the competitive structure of the banking industry varies across countries. As an example, the financial systems in Greece and Belgium have a relatively high degree of concentration. In contrast, the banking sectors in France and Germany have been much more competitive. However, in recent years, there has been a considerable increase in consolidation among banks in many countries. Furthermore, due to the global financial crisis, consolidation has advanced at an even more aggressive pace.
In response, policymakers have expressed concern about the resulting impact on interest rates and the degree of influence of monetary policy. Existing empirical studies indicate that these concerns are legitimate. To begin, Hannan (1991) and Corvoisier and Gropp (2002) argue that borrowers in markets with higher concentration ratios face higher costs for loans. Moreover, they may also experience more difficulty obtaining access to credit Beck, Demirguc-Kunt and Maksimovic (2003) document that credit rationing occurs more often in concentrated banking systems. Other studies emphasize that concentration affects deposit rates.
In addition to distortions from market power, there is a large body of research that stresses that inflation inhibits credit market activity. In particular, Boyd, Levine, and Smith (2001) point out that less lending takes place in countries with higher inflation rates. Therefore, monetary policy can contribute to financial market frictions.
This paper seeks to fill an important existing gap in the literature on financial market activity. Notably, very little research investigates how the transmission channels of monetary policy depend on the degree of competition in financial markets. That is, we view that the effects of monetary policy likely reflect strategic interactions among financial institutions. Therefore, the design of policy should account for the type of strategic behavior and barriers to entry. In an attempt to address these issues, we construct a framework in which banks act as Cournot competitors in the credit market. In contrast, depositors obtain insurance against liquidity risk by depositing their funds in financial institutions. Furthermore, as in Schreft and Smith (1997), spatial separation and private information generate a transactions role for money.
As a benchmark, the paper begins by studying an economy in the presence of non-cooperative behavior. To be expected, the results indicate that a higher degree of banking competition leads to an increase in loans and lower interest rates. However, the type of strategic interactions and the degree of entry bear significant implications for the effects of monetary policy. Specifically, under non-cooperative behavior and limited entry, monetary policy only affects the rate of return to money. Therefore, it does not have any impact on the credit market. In contrast, under endogenous entry, inflation lowers the return to money and interferes with the ability of banks to provide risk pooling services. Consequently, money growth discourages bank entry and leads to higher costs of loans. Due to the negative impact of inflation on credit market outcomes, the Friedman rule is the optimal monetary policy.
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