Abstract - The Social Costs of a Credit Monopoly

Banks provide credit and take deposits. Whereas a high price in the credit market increases banks’ retained earnings and attracts more deposits, it reduces lending if borrowers are sufficiently poor to be tempted by diversion. Thus, optimal bank market structure trades off the benefits of monopoly banking in attracting deposits against losses due to tighter credit. The model shows that market structure is irrelevant if both banks and borrowers lack resources. Monopoly banking induces tighter credit rationing if borrowers are poor and banks are liquid, and increases lending if borrowers are wealthy and banks are constrained. The results indicate that improved legal protection of creditors is more efficient than enhanced legal protection of depositors, and that subsidies to firms lead to better outcomes than subsidies to banks, unless banks are financially distressed and borrowers wealthy. These findings shed light on the policy measures taken to alleviate the recent financial crisis.

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