Abstract
We analyze risk taking behavior of banks in the context of spatial competition. Banks mobilize unsecured deposits by offering deposit rates, which they invest either in a prudent or 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 power that the banks enjoyed in the deposit market is low, banks invest in the gambling asset. On the other hand, for sufficiently high levels of market power, all banks choose the prudent asset to invest in. We further show that a merger of two neighboring banks increases the likelihood of prudent behavior. Also, introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem if the insurance premium is sufficiently low. Finally, we introduce a loan market where the borrowers of the banks choose the investment strategy prior to the deposit contracts. We show that as the market power that the banks enjoy in the loan market increases the borrowers tend to take more risk.
Highlights
Competition in banking sectors is often conducive to banks being involved in high-risk activities. Keeley (1990), Hellmann, Murdock and Stiglitz (2000) and Repullo (2004), among many others, argue that high competition in the deposit market reduces a bank’s incentives for prudent behaviour through the reduction of a bank’s franchise value
The main purposes of this paper are to analyse the nature of the association between market power and bank risk taking when banks compete in a monopolistically competitive deposit market, and exploit such association to study the effects of bank mergers and deposit insurance on the risk taking behaviour
We show that in equilibrium there is a negative association between market power and bank risk taking
Summary
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 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 power is low, banks invest in the gambling asset. For sufficiently high levels of market power, 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. Introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem.
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