Efficient or systemic banks: Can regulation strike a deal?

Should there be few large or several small banks? Large banks benefit from scale economies, but their default can be systemic. This paper develops a macroeconomic model with heterogeneous banks to study the efficiency versus financial-stability trade-off. Scale economies and default losses are calibrated using micro-data. Unlike representative bank models, a novel banking-dynamics channel of regulation emerges – the endogenous response in banks' size-distribution matters for welfare. Capital regulation that equalizes leverage, default rate, or expected loss across banks fails to account for the size-dependent trade-off. Optimal regulation is size-dependent, features a hump-shaped welfare response, and induces more medium-sized banks.