Non-performing loans, expectations and banking stability: A dynamic model

This paper proposes dynamic oligopolistic models to describe heterogenous banks that compete in the loan market. Two boundedly rational banks adopt an adaptive behavior to increase their profits under different assumptions of limited information and bounded computational ability, in the presence of a share of credits that might not be reimbursed (i.e. non-performing loans). Each Nash equilibrium is an equilibrium point of the dynamic adjustments as well. Thus, the repeated strategic interactions between banks may converge to a rational equilibrium according to the parameters’ values and the initial condi- tions. As a case study, we assume an isoelastic nonlinear demand and linear costs as in Puu (1991), and we analyze the influence of the economic parameters on the local stability of the unique equilibrium, as well as the kinds of attractors that characterize the long-run behavior of the banks. Moreover, we study the global structure of the basins of attraction and the degrees of stability of the Nash equilibrium under two different dynamic adjustments: adaptive best reply and gradient dynamics. We obtain interesting policy insights on how different risk factors interact to generate banking stress and fragility. Finally, we show that different monetary policies set by the Central Bank may produce a variety of lending behaviors affecting banking stability.