Competition for Deposits, Risk of Failure, and Regulation in Banking

Carmen Matutes and Xavier Vives

CEPR Financial Markets Paper from European Science Foundation Network in Financial Markets, c/o C.E.P.R, 33 Great Sutton Street, London EC1V 0DX.

Abstract: We develop a model of banking competition for deposits based on modern financial intermediation theory and industrial organization analysis. The standard demand deposit contract makes banks vulnerable to failure and introduces (endogenous) expectations-based vertical differentiation. A multiplicity of equilibria exist due to a coordination problem among depositors. Minimum size investments and diversification economies accentuate the multiplicity problem and introduce the possibility of confidence crises. It is found that `excessive' competition is not responsible for the fragility of unregulated banking (the multiplicity problem) but nevertheless competition is socially excessive at bench-mark market equilibria. Our framework allows us to disentangle the effects of failure perceptions on rivalry. We find that a safer bank will command a higher margin and market share, and that in a symmetric equilibrium the possibility of failure softens competition. Further, fair and risk- based deposit insurance, even in the absence of moral hazard problems, induces competition above uninsured market levels introducing a rationale for deposit rate regulation. Our analysis provides a framework to assess the welfare trade-offs associated with deposit insurance, uncovering positive effects like extending the market and minimizing frictions, beyond well- known stabilizing consequences.

Keywords: Banking Competition; Risk; Network Externalities; Vertical Differentiation; Financial Intermediation; Deposit Insurance (search for similar items in EconPapers)
Date: 1992-09
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Working Paper: Competition for Deposits, Risk of Failure, and Regulation in Banking (1992)
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