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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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1177.

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Date of creation: May 1995
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Handle: RePEc:cpr:ceprdp:1177
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  1. 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.
  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. 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.
  4. Matutes, Carmen & Vives, Xavier, 1996. "Competition for Deposits, Fragility, and Insurance," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 184-216, April.
  5. Ben S. Bernanke, 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," NBER Working Papers 1054, National Bureau of Economic Research, Inc.
  6. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  7. 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.
  8. Allen N. Berger & Richard J. Herring & Giorgio P. Szego, 1995. "The role of capital in financial institutions," Finance and Economics Discussion Series 95-23, Board of Governors of the Federal Reserve System (U.S.).
  9. Yanelle, Marie-Odile, 1989. "The strategic analysis of intermediation," European Economic Review, Elsevier, vol. 33(2-3), pages 294-301, March.
  10. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  11. Hannan, Timothy H & Hanweck, Gerald A, 1988. "Bank Insolvency Risk and the Market for Large Certificates of Deposit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 203-11, May.
  12. Vives, X., 1988. "Nash Equilibrium With Strategic Complementarities," UFAE and IAE Working Papers 107-88, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  13. 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.
  14. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
  15. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
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