Business Cycles: A Role for Imperfect Competition in the Banking System

Federico S. Mandelman
Working Paper 2006-21
November 2006

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This paper studies the cyclical pattern of ex post markups in the banking system using balance-sheet data for a large set of countries. Markups are strongly countercyclical even after controlling for financial development, banking concentration, operational costs, inflation, and simultaneity or reverse causation. The countercyclical pattern is explained by the procyclical entry of foreign banks, which occurs mostly at the wholesale level and signals the intention to spread to the retail level. My hypothesis is that wholesale entry triggers incumbents' limit-pricing strategies, which are aimed at deterring entry into retail niches and which, in turn, dampen bank markups. In the second part of the paper, I develop a general equilibrium model that accounts for these features of the data. I find that this monopolistic behavior in the intermediary financial sector increases the volatility of real variables and amplifies the business cycle. I interpret this bank-supply channel as an extension of the credit channel pioneered by Bernanke and Blinder (1988).

JEL classification: C23, E32, G21, L12, O16

Key words: countercyclical bank markups, limit pricing, business cycles, panel data, generalized method of moments

The author gratefully acknowledges Fabio Ghironi, Peter Ireland, and Fabio Schiantarelli for their invaluable guidance. He also thanks Ingela Alger, Stephen Bond, Luisa Lambertini, Hideo Konishi, Todd Prono, Julio Rotemberg, Richard Tresch, and colleagues at the New York Fed, the Atlanta Fed, the R@BC workshop at Boston College, Universidad Nacional de la Plata, Universidad del CEMA, the University of Torcuado Di Tella, Universidad de San Andrés, the Ninth World Congress of the Econometric Society, and the central bank of Argentina. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions regarding content to Federico Mandelman, Research Economist and Assistant Policy Adviser, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309, 404-498-8785,

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.