Vertical Differentiation, Risk-Taking and Retail Funding

Results of previous studies of the relationship between bank competition and bank risk-taking have differed in findings but most have used the same sort of barriers to perfect competition, such as entry barriers and differences in bank default risk. This study suggests that banks that compete more effectively in the deposit market using nonprice features such as differences in services and advertising gain market power and such market power gives them incentives to take less risk. Banks that compete less effectively take more risk. Empirical evidence supports the predictions of the model.