1. INTRODUCTION

It is well known that banks are special in that they are vulnerable to instability. As the numerous episodes of crises show, banks are fragile and are prone to take excessive risks. Their function as intermediaries between firms and borrowers and the maturity transformation they operate in their asset-liability management make banks play an important role as providers of liquidity to depositors but also exposes them to runs and systemic crises. The great reliance on deposits as source of funds creates a severe agency problem between banks and depositors, in that, being subject to limited liability, banks do not bear the downside risk and have strong incentives to choose risks that are excessive from the viewpoint of depositors. The need of a stable banking sector, together with that of protecting consumers, provides the motivation for the introduction of deposit insurance schemes and lender-of-last-resort facilities. These safety arrangements are effective in pursuing a stable system, but they introduce several distortions and call for further regulatory measures, such as capital requirements.

Whereas the speciality of the banking system and the need of regulation have attracted much attention in both academic and policy debates, the issue of how competition affects the stability of the system and the effectiveness of regulation is not well understood yet. The desirability of competition in the banking sector has been...