Market Structure and Risk Taking in the Banking Industry∗

We demonstrate that the common view according to which an increase in competition leads banks to increased risk taking fails to hold in an environment where homogeneous loss averse consumers can choose in which bank to make a deposit based on their knowledge of the riskiness incorporated in the banks’ outstanding loan portfolios. With an exclusive focus on imperfect competition we find that banks’ incentives for risk taking are invariant to a change in the banking market structure from duopoly to monopoly. Finally, we show that deposit insurance would eliminate the gains from bank competition when banks use asset quality as a strategic instrument.