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Journal of Economics

, Volume 114, Issue 2, pp 177–204 | Cite as

On the relationship between market power and bank risk taking

  • Kaniska Dam
  • Marc Escrihuela-Villar
  • Santiago Sánchez-Pagés
Article

Abstract

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.

Keywords

Bank competition Risk taking Mergers 

JEL Classification

D43 G28 G34 

Notes

Acknowledgments

We are grateful to three anonymous referees for their valuable comments which helped improve the paper significantly. We also owe thanks to Lluís Bru, Ramon Faulí, Fausto Hernández, Antonio Jiménez-Martínez, Inés Macho-Stadler, David Pérez-Castrillo, József Sá kovics and Javier Suárez for helpful suggestions on the earlier and present versions of the paper.

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Copyright information

© Springer-Verlag Wien 2014

Authors and Affiliations

  • Kaniska Dam
    • 1
  • Marc Escrihuela-Villar
    • 2
  • Santiago Sánchez-Pagés
    • 3
  1. 1.Centro de Investigación y Docencia EconómicasMexico CityMexico
  2. 2.Departamento Economía AplicadaEdificio Jovellanos CtraPalma de MallorcaSpain
  3. 3.Department of Economic TheoryUniversity of BarcelonaBarcelonaSpain

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