4. Competition and stability: A real trade off? The analysis of the potential trade-off between competition and stability has gained significant importance in the academic literature in the last decade. Despite this, the results are still not completely conclusive.
Some studies have shown that coordination failures and panic runs can occur independently of the degree of competition in the market. In a model with elements of product differentiation, network externalities and possibility of bank failures, Matutes and Vives (1996) show that depositors have self-fulfilling perceptions of banks’ success probabilities that lead to multiple equilibria. One equilibrium sees no banks being active. This is due to a coordination problem among depositors, which occurs irrespectively of the degree of competition in the deposit market. However, by raising deposit rates, more competition may exacerbate the coordination problem among depositors. As in Diamond and Dybvig (1983), deposit insurance eliminates the non-banking equilibrium and stabilizes the system, but it is not always welfare-enhancing.
Following the empirically findings in Keeley (1990) of a negative effect of higher charter values on risk taking, the theoretical literature has initially stressed how competition worsens banks' incentives to take risk (e.g., Allen and Gale, 2004) and how regulation can help in mitigating this perverse link (e.g., Hellmann et al., 2000; Matutes and Vives, 2000). The general idea is that greater competition reduces banks' charter values (or rents available to shareholders and/or managers). This increases the attractiveness of the gains from taking risks, and therefore the incentives to exploit the non-convexity in banks' payoff functions.
This result implies the need of regulating the banking system to limit the adverse consequences of intense competition and achieve stability. One possibility is to limit competition directly through ceilings on interest rates or limits on entry. Another possibility is to design regulation so to "correct" the negative effects of competition on banks’ risk taking. Risk-adjusted deposit insurance premia or appropriate capital requirements may be sufficient for this purpose, even though, depending on the