We study banking competition and stability in a 2-period economy. Firms need loans to operate, and in case of a real shock, a fraction of firms default. Banks bound by capital adequacy constraints lend less and amplify the initial shock. The magnification depends on the intensity of bank competition. The model admits prudent and imprudent equilibria, where banks collapse after shocks. We find existence conditions for a prudent equilibrium. Competition increases efficiency but leads to higher second period variance and makes imprudent equilibria more attractive. We examine the moderating effect of regulation and forbearance.
JEL: E44, G18, L16.
Keywords: Bank competition, efficiency., forbearance., stability