The cost of being safer in banking: market power loss

Abstract

To promote safety at financial institutions, Basel III introduced two new liquidity rules, the net stable funding ratio and the liquidity coverage ratio. However, the issue of how the new rules affect the market power of banks has not been investigated. This paper fills the gap by analyzing how an increase in bank liquidity associates with market power for a sample of 2,665 unique commercial banks and bank holding companies in the U.S. during 2000–2015. We find a significantly negative correlation between liquidity and market power. The result is robust over different measures of liquidity and market power and different estimation methods. Our further investigation reveals that banks can expand their business aggressively to enjoy economies of scale to mitigate the negative effect of liquidity on market power. © 2019