DP15063 Interest Rates, Market Power, and Financial Stability

Author(s): David Martinez Miera, Rafael Repullo
Publication Date: July 2020
Keyword(s): Bank monitoring, bank risk-taking, Imperfect Competition, intermediation margins, monetary policy
JEL(s): E52, G21, L13
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15063

This paper shows the relevance of market power to assess the effects of safe interest rates on financial intermediaries' risk-taking decisions. We consider an economy where (i) intermediaries have market power in granting loans, (ii) intermediaries monitor borrowers which lowers their probability of default, and (iii) monitoring is costly and unobservable which creates a moral hazard problem with uninsured depositors. We show that lower safe rates lead to lower intermediation margins and higher risk-taking when intermediaries have low market power, but the result reverses for high market power. We examine the robustness of this result to introducing non-monitored market finance, heterogeneity in monitoring costs, and entry and exit of intermediaries. We also consider the effect of replacing uninsured by insured deposits, market power in raising deposits, and funding with both deposits and capital.