Working Paper: CEPR ID: DP1177
Authors: Carmen Matutes; Xavier Vives
Abstract: We develop a model of banking competition which allows us to disentangle the roles that limited liability, deposit insurance (both with flat and risk-based premia), and rivalry for deposits play in determining risk-taking incentives both in the asset and the liability side of the balance sheet. We find that in all market configurations (uninsured or insured) banking rivalry yields excessive deposit rates when social failure costs are high or when competition is intense. Maximal risk-taking incentives (on the liability and asset sides) exist with flat-premium deposit insurance and minimal with risk-based insurance. In an uninsured market risk taking on the asset side is implied by limited liability and the presence of moral hazard (asset risk not observable). With flat-premium deposit insurance maximum risk-taking incentives exist even if there is no moral hazard. Finally, we can extricate the role of rate and asset regulation both in the case of insured and uninsured deposits.
Keywords: excessive competition; risk taking; limited liability; investor protection; rate regulation; asset restrictions
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| competition intensity (L13) | deposit rates (E43) |
| type of deposit insurance (G28) | risk-taking incentives (G11) |
| limited liability (K13) | risk-taking on the asset side (G11) |
| moral hazard (G52) | risk-taking on the asset side (G11) |
| flat premium deposit insurance (G22) | rate rivalry (Z23) |
| risk-based insurance (G22) | limited liability cancellation (G33) |
| risk-based insurance (G22) | lower equilibrium rates (E43) |
| rate regulation (L51) | welfare maximization (D69) |