Imperfect competition, risk taking, and regulation in banking

We asses the welfare implications of banking competition under various depo sit insurance regimes in a model of imperfect competition with social failu re costs and where banks are subject to limited liability. We study the lin ks between competition for deposits and risk taking incentives, and conclud e that the welfare performance of the market and the appropriateness of alt ernative regulatory measures depend on the degree of rivalry and the deposi t insurance regime. Specifically, when competition is intense and the socia l failure costs high, deposit rates are excessive both in a free market and with risk-based insurance. If insurance premiums are insensitive to risk t hen the same is true even if there is no social cost of failure. We find al so that in an uninsured market with nonobservable portfolio risk or with fl at-premium deposit insurance deposit regulation (rate regulation or deposit limits) and direct asset restrictions are complementary tools to improve w elfare. In an uninsured market with observable portfolio risk or with risk- based insurance deposit regulation may be a sufficient instrument to improv e welfare. (C) 2000 Elsevier Science B.V. All rights reserved.