Imperfect competition, risk taking, and regulation in banking

Abstract

We asses the welfare implications of banking competition under various deposit insurance regimes in a model of imperfect competition with social failure costs and where banks are subject to limited liability. We study the links between competition for deposits and risk taking incentives, and conclude that the welfare performance of the market and the appropriateness of alternative regulatory measures depend on the degree of rivalry and the deposit insurance regime. Specifically, when competition is intense and the social failure costs high, deposit rates are excessive both in a free market and with risk-based insurance. If insurance premiums are insensitive to risk then the same is true even if there is no social cost of failure. We find also that in an uninsured market with nonobservable portfolio risk or with flat-premium deposit insurance deposit regulation (rate regulation or deposit limits) and direct asset restrictions are complementary tools to improve welfare. In an uninsured market with observable portfolio risk or with risk-based insurance deposit regulation may be a sufficient instrument to improve welfare.