Chapter Five: The Industrial Organization of Banking Industry

5.1. Introduction
5.2. A model of a perfectly competitive banking sector
Model setup
  A change of the monetary base 𝑀0 or an open market operation (a change in B) has a direct
effect on money and credit.

The money multiplier

 The money multiplier is defined by the effect of a marginal change in the monetary base (or an
open market operation) on the quantity of money in circulation:

The Credit Multiplier Approach

 Similarly, the credit multiplier is defined as the effect on credit of such marginal
changes:
 Result 5.1. Interpretation
The competitive equilibrium of the banking sector
 Result 5.2. Interpretation
5.3. The Monti-Klein model of a monopolistic bank
 π 17
 Thus the bank’s profit is the sum of the intermediation margins on loans and deposits, net of
management costs.
 These equations are simply the adaptation to the banking sector of the
familiar equalities between Lerner indices (price minus cost divided by price)
and inverse elasticities.
 The greater the market power of the bank on deposits (resp. loans), the
smaller the elasticity and the higher the Lerner index.
 The intermediation margins are higher when banks have a higher market
power.
Result 5.3.
5.4. Monopolistic competition

 What is the effect of deposit rate regulation on credit rates

 The sum of all depositors’ transportation
costs can be computed by dividing the circle
into 2n equal arcs,

22
Solving the first-order condition, we find
𝑡𝐿
F--4𝑛
23
For n yields:
 How many banks will appear if banking competition is completely free (no entry
restrictions, no rate regulations)?
 To answer this question, consider that n banks enter simultaneously.

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25

26
 26

27

 Result 5.4.

28

Result 5.4
 The equation 28 shows that free competition leads to too many banks.
 The question is now to determine which type of regulation is appropriate. For
instance, in such a context, imposing a reserve requirement on deposits is
equivalent to decreasing the return rate r on the banks’ assets.
 Equation 28 shows that this has no effect on the number of active banks at
equilibrium.
 On the contrary, any measure leading directly (entry, branching restrictions) or
indirectly (taxation, chartering fees, capital requirements) to restricting the
number of active banks will be welfare-improving as long as the whole market
remains served.
 This can be seen in particular as a justification of branching restrictions, which
exist or have existed in many countries.
5.5. Oligopolistic competition

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 It is easy to see that there is a unique equilibrium, in which each bank sets
𝐷∗ 𝑛 =𝐷 ∗ /N and 𝐿∗ 𝑛 =𝐿∗ /N. The first-order conditions and

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32

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34

 Result 5.5.
5.5. Relationship Banking
A definition
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36
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 Result 5.6