On the Relationship between Market Power and Bank Risk Taking

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

Research output: Working paperDiscussion paper

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.
Original languageEnglish
PublisherEdinburgh School of Economics Discussion Paper Series
Number of pages33
Publication statusPublished - 2009

Publication series

NameESE Discussion Papers
No.187

Keywords

  • D43
  • G28
  • G34

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