with Dean Corbae
Last version: February 2025 [download pdf]
Abstract: We develop a simple model of banking industry dynamics to study the relation between commercial bank market structure, entry and exit along the business cycle, and the riskiness of commercial bank loans as measured by default frequencies. Motivated by the data, we analyze a Stackelberg environment where a small number of dominant banks choose their loan supply strategically before a large number of small banks (the competitive fringe) make their loan choices. A nontrivial endogenous bank size distribution arises out of entry and exit in response to aggregate and regional shocks to borrowers' production technologies and banks' stochastic deposit inflows. The model is estimated using first moments of aggregate and cross-sectional statistics for a panel of the entire U.S. commercial banking industry. Given the model has a subset of non-atomistic banks that generate granular spillovers to the aggregate loan market arising from idiosyncratic shocks and hence pose systemic risk, we study the costs and benefits of too-big-to-fail policies.Â