The mechanics of commercial banking liberalization and growth

This paper formalizes the effects of liberalization across the border of deposit-taking and lending activities on the regime of competition in the banking market and on the rate of growth of the economy. We extend two economy based Deidda (2006)'s banking model in which originally each economy hosts at least one operating bank. We introduce two GATS-defined modes of commercial banking liberalization - namely the Commercial Presence mode and the Cross-Border mode. Additionally, we introduce the possibility of strategic behavior by competing banks in equilibrium. The extended model provides a causal link between the cost structure of the banking industry, the regime of competition in the liberalized banking sector and the rate of growth of the economy under alternative modes of liberalization. In particular, we show a threshold effect in terms of economic development: above certain economic development the banking sector operates competitively and supports an accelerating rate of growth, generating a bidirectional, self-reinforcing link between commercial banking liberalization and growth. The pace of growth is further increased, with respect to a scenario where such behavior is not present, by the presence of strategic behavior by competing banks in equilibrium.