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Imperfect competition, risk taking, and regulation in banking

  • Matutes, Carmen
  • Vives, Xavier

We develop a model of banking competition which allows us to disentangle the roles that limited liability, deposit insurance (both with flat and risk-based premia), and rivalry for deposits play in determining risk-taking incentives both in the asset and the liability side of the balance sheet. We find that in all market configurations (uninsured or insured) banking rivalry yields excessive deposit rates when social failure costs are high or when competition is intense. Maximal risk-taking incentives (on the liability and asset sides) exist with flat-premium deposit insurance and minimal with risk-based insurance. In an uninsured market risk taking on the asset side is implied by limited liability and the presence of moral hazard (asset risk not observable). With flat-premium deposit insurance maximum risk-taking incentives exist even if there is no moral hazard. Finally, we can extricate the role of rate and asset regulation both in the case of insured and uninsured deposits.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 44 (2000)
Issue (Month): 1 (January)
Pages: 1-34

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Handle: RePEc:eee:eecrev:v:44:y:2000:i:1:p:1-34
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  1. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  2. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  3. Matutes, Carmen & Vives, Xavier, 1996. "Competition for Deposits, Fragility, and Insurance," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 184-216, April.
  4. Cerasi, Vittoria & Daltung, Sonja, 2000. "The optimal size of a bank: Costs and benefits of diversification," European Economic Review, Elsevier, vol. 44(9), pages 1701-1726, October.
  5. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  6. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
  7. Smith, Bruce D., 1984. "Private information, deposit interest rates, and the `stability' of the banking system," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 293-317, November.
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  9. Allen N. Berger & Richard J. Herring & Giorgio P. Szegö, 1995. "The Role of Capital in Financial Institutions," Center for Financial Institutions Working Papers 95-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. Vives, Xavier, 1990. "Nash equilibrium with strategic complementarities," Journal of Mathematical Economics, Elsevier, vol. 19(3), pages 305-321.
  11. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
  12. Timothy H. Hannan & Gerald A. Hanweck, 1986. "Bank insolvency risk and the market for large certificates of deposit," Working Papers in Banking, Finance and Microeconomics 86-1, Board of Governors of the Federal Reserve System (U.S.).
  13. Damien NEVEN & Lars-Hendrik RÖLLER, 1994. "Competition in the European Banking Industry : An Aggregate Structural Model of Competition," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9410, Université de Lausanne, Faculté des HEC, DEEP.
  14. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June.
  15. Yanelle, Marie-Odile, 1989. "The strategic analysis of intermediation," European Economic Review, Elsevier, vol. 33(2-3), pages 294-301, March.
  16. Winters,L. Alan & Venables,Anthony (ed.), 1991. "European Integration," Cambridge Books, Cambridge University Press, number 9780521405287.
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