On the Relationship between Market Concentration and Bank Risk Taking

We analyse risk-taking behaviour of banks in the context of spatial competition. Banks mobilise unsecured deposits by offering deposit rates, which they invest either in a prudent or in a gambling asset. Limited liability along with high return of a successful gamble induce moral hazard at the bank level. We show that when the market concentration is low, banks invest in the gambling asset. On the other hand, for sufficiently high levels of market concentration, all banks choose the prudent asset to invest in. We further show that a merger of two neighboring banks increases the likelihood of prudent behaviour. Finally, introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem.