Revisiting Banking Competition and Fragility : A “Too Big to Save” Perspective

I study the relationship between competition in the banking sector and financial fragility. I identify a new “too big to save” channel through which increased competition amplifies fragility in the banking system. In equilibrium, a more competitive banking system will be larger because more total liabilities are issued to depositors. The relative size of banking liabilities to the government’s fiscal capacity will be smaller. In the event of a run, depositors anticipate smaller bailouts as a fraction of banks’ liabilities, which gives them stronger incentives to run on their banks. In other words, increased competition can make the banking system “too big to save.” I show that a form of interest rate ceiling is a more efficient way to promote financial stability in this setting than restricting competition