Bank Runs, Bank Competition and Opacity
How is the stability of the financial sector affected by competition in the deposit market and by banks’ choices about the level of transparency? We propose a model in which both elements interact and influence investors’ withdrawal decisions and banks’ level of distress (that is, the probability banks will default on their debt). The model also shows how measures regulating bank competition and bank transparency affect the stability of the financial sector.
Banks face a trade-off when choosing how transparent they should be—that is, how much information they should provide about their investment portfolios. On the one hand, greater transparency reduces costly investor withdrawals when the bank is solvent because investors have better information about bank returns. On the other hand, greater transparency improves the information of competitors, who are then more likely to enter the market and reduce the value of future bank profits.
We show that policies that aim to increase bank competition lead to higher bank deposit rates, increasing both withdrawal incentives and instability. Policies that aim to increase transparency in the banking sector can also increase instability. The reason is that when banks are more transparent, they have incentives to raise their deposit rates—which leads to larger withdrawal incentives and higher levels of distress.