Universität Bonn

Department of Economics

David Martinez-Miera - Universidad Carlos III de Madrid

„Interest Rates, Market Power and Financial Stability", with Rafael Repullo

Abstract

This paper shows the relevance of market power to assess the effects of 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 deposit insurance, market power in raising deposits, and funding with both deposits and capital.

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