Systemic Risk in Financial Intermediation: An International Perspective

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AbstractTitle: Systemic Risk in Financial Intermediation: An international perspectiveProposal Number: SES - 1227613Katheryn N. RussUniversity of California, Davis andNational Bureau of Economic ResearchThe recent financial crisis prompted intense policy debate over the appropriate role for regulation in the growth and reach of large lending institutions in the U.S. and worldwide. The policy debate has far outpaced economic theory, which still provides no models featuring an array of banks that vary in size and strategically (Bertrand) compete in the macroeconomy. The need to model a large number of heterogeneous banks, each setting its own competitive markup over lending costs, has presented a serious technical challenge. This project uses recent advances in the theory of heterogeneous firms to fill the conceptual gap and present a new framework for policy analysis.The project provides a new theoretical framework for evaluating the effects of increasing the market share of the largest banks on the pricing of loans and on macroeconomic stability. Existing models of the banking sector (1) require banks to be identical or exogenously limit their number to two or three and (2) predict that increasing concentration coincides with increasing market power when pricing loans. Empirical studies find a weak link or no link at all between concentration and the markups that banks charge borrowers over the cost of funds, a common measure of market power. This project exploits cross-country data on individual bank balance sheets to generate relevant stylized facts and uses them to construct a new modeling framework that encompasses the very different circumstances of large versus small and financially developed versus less developed countries. The goal is to derive and quantify the macroeconomic implications of a top-heavy distribution of banks, in particular the relationship between bank size and volatility in the aggregate credit supply and the gross domestic product.The broader impact of the project is its guide for regulatory policy. The central theme of the project is that one size does not fit all when it comes to evaluating the role of large banks. Increasing capital requirements may have no impact on the cost of loans and little impact on market concentration or macroeconomic volatility in large or highly financially developed countries, yet can increase both borrowing costs and macroeconomic volatility in small or less financially developed countries. Innovation in the financial sector can increase both access to credit and macroeconomic volatility, presenting a tradeoff for policymakers. The new modeling and empirics in this study will quantify these crucial nuances for more accurate cost-benefit analysis.