Bank Competition and Real Economic Activity : A Financial Intermediation Approach

This paper provides a financial intermediation approach to analyzing the real effects of bank market power. We start from the idea that banks, when operating in imperfectly competitive credit markets, can face a trade-off between exploiting their loan pricing power and enforcing hard corporate budget constraints: as banks hold larger stakes in their borrowers' projects, they become less committed to penalize misbehaving borrowers by terminating their projects. This can have negative effects for corporate managerial incentives ex ante. At the same time, however, an increase in bank market power also entails lower deposit rates. This reduces depositors' implicit stake in the real sector, which may sharpen corporate managerial incentives. Due to these effects, the model predicts an inversely U-shaped relation between bank market power and real sector performance. This is consistent with the available empirical evidence