On the Relationship between Market Power and Bank Risk Taking

Kaniska Dam, Marc Escrihuela-Villar and Santiago Sánchez-Pagés ()

ESE Discussion Papers from Edinburgh School of Economics, University of Edinburgh

Abstract: 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. 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 behaviour. Finally, introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem.

JEL-codes: D43 G28 G34 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-bec, nep-com, nep-cta and nep-ias
Date: 2009-02
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Persistent link: http://EconPapers.repec.org/RePEc:edn:esedps:187

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