Introduction

The purpose of this paper is to examine the consequences of interbank competition and bank-capital market competition on the portfolio choices of banks and the welfare of borrowers in a regulatory environment of (de facto) complete deposit insurance. Our focus is on an industry characterized by ‘relationship banking’, i.e. a setting involving repeated, bilateral credit transactions between banks and borrowers. A key feature of relationship banking is the intertemporal accumulation of proprietary borrower-specific information in the hands of the bank, and the consequent creation of informational rents (see Sharpe, 1990). To the extent that these rents are shared by the bank and the borrower, both parties see a value in continuing their relationship. The desire to protect such relationships affects the bank's asset portfolio choice.

A second factor that affects the bank's asset portfolio choice is deposit insurance. As is well known, risk-insensitive deposit insurance pricing induces socially wasteful risk taking by banks (see Merton, 1977). Partially mitigating this fondness for risk is the threat of bank charter termination by the insurer, but this threat is effective only if bank charters are sufficiently valuable (see Chan, Greenbaum and Thakor, 1992). We show that relationship banking provides one source of value for the bank charter. Relationship banking diminishes in value, however, as the banking industry becomes more competitive, so that increased interbank competition accentuates the attractiveness of risk pursuit initially engendered by deposit insurance. The same holds true for increased competition from the capital market.

This framework provides a useful cognitive link between bank market structure, the capital market, relationship banking, deposit insurance and bank portfolio choice.