On the Influence of capital Requirements on Competition and Risk taking in Banking
This paper focuses on the interaction between regulation and competition in an industrial organisation model. We analyse how capital requirements a.ect the pro.tability of two banks that compete as Cournot duopolists on a market for loans. Bank management of both banks choose optimal levels of loans provided, equity ratio and e.ort to reduce loan losses so as to maximise pro.ts. It is shown that the introduction of a just binding capital constraint improves the pro.tability of the constrained bank, whereas the pro.tability of its unrestricted competitor declines. Especially, if an ine.cient bank chooses a strategy that might result in bankruptcy, capital requirements are welfare improving. However, also under conditions that both banks would also never default in the absence of regulation, mild capital requirements can be bene.cial as they stimulate banks to provide more loans. Too high requirements on the other hand relatively favour the ine.cient bank, and result in welfare losses.
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