Banking Competition and Stability: The Role of Leverage

• Authors: Xavier Freixas.
• BSE Working Paper: 110263 | September 15
• Keywords: financial stability , banking competition , leverage
• JEL codes: G21, G28
• financial stability
• banking competition
• leverage

This paper re-examines 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. We show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on a bank’s type of funding (retail deposits vs. wholesale debts) and whether leverage is exogenous or endogenous. In particular, we argue that while competition might increase financial stability in a classical originate-to-hold banking industry, the opposite can be true for an originate-to-distribute banking industry with a large fraction of market short-term funding.