On the relationship between market power and bank risk taking

Kaniska Dam, Marc Escrihuela-Villar, Santiago Sanchez-Pages

Research output: Contribution to journalArticlepeer-review


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.
Original languageEnglish
Pages (from-to)177-204
JournalJournal of Economics
Issue number2
Early online date14 Jan 2014
Publication statusPublished - Mar 2015


  • bank competition
  • risk taking
  • mergers
  • market concentration


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