In most industries, competition benefits consumers by encouraging firms to reduce costs and improve service. Besanko and Thakor join a growing chorus of academics who argue that the banking industry is different. Deposit insurance is a key element that distinguishes the impact of competition in banking. Competition in the financial market benefits borrowers in the short run by lowering the price of loans, but competition also causes banks to operate on thinner margins and deposit insurance may tempt banks to hold risky portfolios, knowing that they are shielded from down-side risk. Thin margins and risky portfolios increase the risk that a bank may fail, which is bad for borrowers who have developed valued relationships with the failed bank.

Deposit insurance is a ‘put option’ that allows the bank to sell its assets at a zero price if liabilities exceed assets. If a bank faces two alternative loan prospects, both with a zero expected return, the alternative with a higher variance (the more risky loan) would offer an insured bank a higher expected profit. Reducing the extent of competition would have (roughly) the effect of increasing the returns to the bank in every state of nature, so the bank would be less likely to exercise the deposit insurance put option. A less competitive environment would diminish the value of deposit insurance and make the bank more accountable for the hazards as well as the benefits of a risky loan. In the absence of competition, the bank would accept the more risky prospect only if the expected returns compensated the bank for its higher risk of loan losses.