“Interest Rates, Market Power, and Financial Stability” with Professor Rafael Repullo

This paper shows that banks’ market power is key to assessing the effects of safe rates on their risk-taking decisions. We consider an economy where banks have market power in lending and privately monitor loans, which reduces their probabilities of default. We show that lower safe rates lead to lower margins and higher risk-taking when banks have low market power, but the result is reversed for high market power. We show that the reversal is stronger when deposits are insured, and it is robust to introducing market power in deposits and endogenous bank leverage.