Financial instability, oligopolistic banking, and monetary growth

This paper analyzes the dynamics of a monetary economy whichis characterized by increasing returns to scale in financialintermediation. The intermediation technology is linear in deposits,but its operation requires a fixed verification cost to overcomethe asymmetric information about a borrower's investment outcome.Intermediaries, termed banks, can avoid the costly duplicationof information disclosure. Due to the non–convexity inintermediation activities, two stationary monetary equilibriaexist. The first is a saddle with high economic activity andhigh competition in banking. In the second equilibrium, competitionbetween banks and economic activity are low. Under adverse economicconditions, the low activity equilibrium can bifurcate intoa sink and the economy may experience periods of financial instabilityand banking crises. Although crises are random events, the economy'sexposure to financial instabilities depends on fundamental conditions.Thus, the predictive power of fundamentals does not contradictthe random theory of crises.