Research Discussion Papers, Bank of Finland
No 21/2000:
The Effects of Competition on Banks’ Risk Taking with and without Deposit Insurance
Juha-Pekka Niinimäki ()
Abstract: We consider the joint effect of competition and deposit
insurance on risk taking by banks when the riskiness of banks is
unobservable to depositors. It turns out that the magnitude of risk taking
depends on the type of bank competition. If the bank is a monopoly or banks
compete only in the loan market, deposit insurance has no effect on risk
taking. In that case the banks are too risky but extreme risk taking is
avoided. In contrast, introducing deposit insurance increases risk taking
if banks compete for deposits. Then, deposit rates become excessively high
and force the banks to take extreme risks. Regarding the effects of
increasing competition when there is deposit insurance, the results imply
that deposit competition encourages risk taking but loan market competition
does not. Our results can be extended more generally to insurance guaranty
funds.
Keywords: deposit insurance; insurance guaranty funds; bank and insurance regulation; moral hazard; credit rationing; financial fragility; (follow links to similar papers)
JEL-Codes: G21; G22; G28; (follow links to similar papers)
25 pages, December 18, 2000
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