State ownership, credit risk and bank competition: a mixed oligopoly approach

Abstract

The recent financial crisis led many governments to buy equity in banks leading to situations of mixed oligopoly in banking markets. We model such a case where a partially state-owned bank competes with a private bank in collecting deposits. The government is purely a welfare maximizer while the private bank maximizes profits. Both banks face risks in the loan market. We show that if credit risk is sufficiently high and there is limited liability, the state-owned bank mitigates depositors' losses by mobilizing less deposits leading to contraction of aggregate deposits. This contradicts the standard mixed oligopoly results in the literature.

Keywords:

• banking
• mixed duopoly
• credit risk

JEL classification:

• G21, L13, L33

Notes

1. While the ownership exceeds 50% is very important, it cannot be denied that any change in will have some effect on the bank behaviour.

2. Exogenously given schemes of deposit insurance can be introduced in our framework without much complication. But in principle the insurer should be allowed to monitor the behaviours of the banks, which is a non-trivial exercise and we do not pursue it here.

3. However, in standard mixed oligopoly models for this to happen constant marginal cost is required. In our banking model, neither the marginal return curve nor the marginal cost curve is constant. But on both dimensions they depend on aggregate deposits. This is a crucial feature of banks, as opposed to standard firms.