Competition and Increasing Returns to Scale: A Model of Bank Size

Authors


  • I am indebted to Dmitri Vinogradov and Giovanni Ko for their enormous help with the exposition and to the anonymous referee and the editor, whose comments greatly improved the study. I thank, for their helpful comments, Roy Bailey, Sanjay Banerji, Hans Gersbach, Xuewen Liu, John Moore, Jean Rochet, Zhen Song, Tuomas Takalo, Huainan Zhao and seminar participants at Zhejiang University, Fudan University, Essex University, Bank of Finland, ETH Zurich and Nottingham Business School.

Abstract

This study examines the causal effects of bank size on banks' survival, asset quality and leverage. Two forces drive these effects: increasing returns to scale derived from banks' expertise and competition. The first enables bigger banks to survive competition better, have higher asset quality and be more leveraged. It drives banks into a race for expansion. This race toughens competition between banks, which edges out small banks and may worsen all banks' asset quality. Consequently, the banking industry will be dominated by a small number of highly leveraged banks. In this study, financial intermediation arises endogenously and co-exists with direct finance.

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