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Competition for Deposits, Risk of Failure, and Regulation in Banking

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  • Carmen Matutes
  • Xavier Vives

Abstract

We develop a model of banking competition for deposits based on modern financial intermediation theory and industrial organization analysis. The standard demand deposit contract makes banks vulnerable to failure and introduces (endogenous) expectations-based vertical differentiation. A multiplicity of equilibria exist due to a coordination problem among depositors. Minimum size investments and diversification economies accentuate the multiplicity problem and introduce the possibility of confidence crises. It is found that `excessive' competition is not responsible for the fragility of unregulated banking (the multiplicity problem) but nevertheless competition is socially excessive at bench-mark market equilibria. Our framework allows us to disentangle the effects of failure perceptions on rivalry. We find that a safer bank will command a higher margin and market share, and that in a symmetric equilibrium the possibility of failure softens competition. Further, fair and risk- based deposit insurance, even in the absence of moral hazard problems, induces competition above uninsured market levels introducing a rationale for deposit rate regulation. Our analysis provides a framework to assess the welfare trade-offs associated with deposit insurance, uncovering positive effects like extending the market and minimizing frictions, beyond well- known stabilizing consequences.

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Bibliographic Info

Paper provided by European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ in its series CEPR Financial Markets Paper with number 0018.

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Date of creation: Sep 1992
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Availability: in print
Handle: RePEc:cpr:ceprfm:0018

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Related research

Keywords: Banking Competition; Risk; Network Externalities; Vertical Differentiation; Financial Intermediation; Deposit Insurance;

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Cited by:
  1. Marques Ibanez, David & Molyneux, Philip, 2001. "Integration of European Banking and Financial Markets," EIFC - Technology and Finance Working Papers 14, United Nations University, Institute for New Technologies.
  2. David Besanko & Anjan V. Thakor, 2004. "Relationship Banking, Deposit Insurance and Bank Portfolio Choice," Finance 0411046, EconWPA.
  3. Juan Coello, 1994. "¿Son las cajas y los bancos estratégicamente equivalentes?," Investigaciones Economicas, Fundación SEPI, vol. 18(2), pages 313-332, May.
  4. Honohan, Patrick & Vittas, Dimitri, 1996. "Bank regulation and the network paradigm : policy implications for developing and transition economies," Policy Research Working Paper Series 1631, The World Bank.

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