Bank Size, Leverage, and Financial Downturns

I construct a macroeconomic model with a financial sector in which the severity of financial downturns depends on size differences in the banking sector and average bank leverage. In my model, a more concentrated banking sector deepens and prolongs financial downturns for two reasons: returns on assets decrease more, and banks sharply decrease the liquidity supply in the interbank market. Calibrated to match the observed long-term concentration in the banking sector, the model shows that a typical adverse financial shock leads to a 1% sharper downturn compared to an economy with a homogeneous banking sector. I further find that the increasing concentration in US banking has increased the volatility of output in the real economy in response to similarly sized financial shocks.