Competition and bank risk taking under differentiated oligopoly

Abstract

We explore the relationship between the degree of competition in the deposit market and the risk taking behavior of banks in a framework where banks compete in differentiated deposit services. As has already been established in the extant literature, we find that an increased degree of competition, measured by greater degree of substitutability or by higher number of banks, induces the banks to take more risk in equilibrium. This result has been established under the assumption that the Banks can invest their deposits directly to a risky project by choosing the optimal level of risk. Next, we show that when banks do not have direct control over the risk level of the projects chosen by their borrowers, the equilibrium level of risk depends neither on the characteristics of the deposit market nor on the number of banks in the financial sector, thereby challenging the so-called positive relationship between deposit market competition and risk already established in the extant literature. We further derive the implications of loan contracts on the equilibrium deposit rates.