Imperfect Banking Competition and the Propagation of Uncertainty Shocks
Series no. 997. Uncertainty shocks, by propagating through the banking sector, play a crucial role in driving business cycle fluctuations. To examine how the recent decline in U.S. banking competition has affected the transmission of these shocks, I develop a dynamic stochastic general equilibrium model featuring heterogeneous banks, imperfect banking competition and financial frictions. The model shows that reduced competition in the banking sector leads to higher borrowing rates and increased risk-taking by borrowers. As a result, uncertainty shocks generate more pronounced increases in defaults and sharper contractions in investment and output in less competitive banking environments. Quantitatively, the model implies that the recent decline in U.S. banking competition results in a 0.1 percentage points larger drop in GDP one year after an uncertainty shock. This finding is supported by panel local projection evidence indicating that lower banking competition amplifies the negative impact of uncertainty on GDP.
Figure – Effects of an uncertainty shock and the recent fall in banking competition
During periods of heightened uncertainty—such as the COVID-19 pandemic or the war in Ukraine—firms are more likely to default due to unpredictable returns. These uncertainty shocks can significantly harm the economy, especially when banking competition is low. In less competitive banking sectors, banks tend to charge higher borrowing rates, which incentivizes firms to take on greater financial risk, thereby increasing their probability of default.
Over the past few decades, the US banking sector has experienced a marked decline in competition. To assess the implications of this trend, I develop a structural macroeconomic model that incorporates financial frictions and imperfect banking competition. In the model, reduced competition amplifies the negative impact of uncertainty shocks through a "risk-shifting" mechanism: higher borrowing costs push borrower to take more risk, leading to more defaults. In response, banks reduce credit supply, further contracting economic activity.
I compare two versions of the model—one calibrated to a high-competition banking environment and the other to a low-competition one, as seen in the US since 2000. As shown in the figure, the results show that in the low-competition scenario, GDP falls by 0.1 percentage points more one year after an uncertainty shock. The mechanism behind this amplification is that higher market power among banks encourages riskier borrower behavior, resulting in a sharper rise in defaults and a stronger pullback in lending. In fact, according to the model, the recent drop in competition has led to a 0.6 percentage point increase in borrower default rates.
These theoretical findings are supported by empirical evidence. Using panel local projection methods on data from 34 countries between 2000 and 2020, I show that increases in uncertainty lead to significantly larger declines in GDP in countries with more concentrated banking sectors. This suggests that banking competition plays a key role in shaping how economies absorb and respond to uncertainty shocks.
Keywords: Financial Frictions, Financial Intermediaries, Heterogeneous Agents, Market Power, Uncertainty
Codes JEL : E32, E44, G21, L13
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Updated on the 2nd of July 2025