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Capital requirements and competition in the banking industry

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  • P.J.G. Vlaar

Abstract

This paper focuses on the interaction between regulation and competition in an industrial organisation model. We analyse how capital requirements affect the profitability of two banks that compete as Cournet duopolists on a market for loans. Bank management of both banks choose optimal levels of loans provided, equity ratio and effort to reduce loan losses so as to maximise profits. From the regulator's point of view, the free market solution is not optimal as private banks do not take into account the consumer surplus and the social cost of bankruptcy (financial stability aspects). It is shown that capital requirements may improve welfare, even under conditions that both banks would never default. Moreover, we find that higher capital requirements impose a higher burden on the inefficient bank than on the efficient one, even though the requirement may only be binding for the efficient bank. If the inefficient bank chooses a strategy that might result in bankrutpcy, capital requirements are particularly welfare improving.

Suggested Citation

  • P.J.G. Vlaar, 2000. "Capital requirements and competition in the banking industry," WO Research Memoranda (discontinued) 634, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:wormem:634
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    File URL: https://www.dnb.nl/binaries/wo0634_tcm46-145941.pdf
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    References listed on IDEAS

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    1. Bhattacharya, Sudipto & Boot, Arnoud W A & Thakor, Anjan V, 1998. "The Economics of Bank Regulation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(4), pages 745-770, November.
    2. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, January.
    3. Marshall, David A. & Prescott, Edward Simpson, 2001. "Bank capital regulation with and without state-contingent penalties," Carnegie-Rochester Conference Series on Public Policy, Elsevier, pages 139-184.
    4. Arnoud Boot & Silva Dezõelan & Todd Milbourn, 1999. "Regulatory Distortions in a Competitive Financial Services Industry," Journal of Financial Services Research, Springer;Western Finance Association, pages 249-259.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Wilko Bolt & Alexander F. Tieman, 2004. "Banking Competition, Risk and Regulation," Scandinavian Journal of Economics, Wiley Blackwell, pages 783-804.
    2. Leonardo Gambacorta & Paolo Emilio Mistrulli, 2003. "Bank Capital and Lending Behaviour: Empirical Evidence for Italy," Temi di discussione (Economic working papers) 486, Bank of Italy, Economic Research and International Relations Area.
    3. Donsyah Yudistira, 2002. "The Impact of Bank Capital Requirements in Indonesia," Finance 0212002, EconWPA, revised 18 May 2003.
    4. Samy Ben Naceur & Magda Kandil, 2008. "Basel Accord and Lending Behavior: Evidence from MENA Region," Working Papers 385, Economic Research Forum, revised 01 Jan 2008.
    5. Sami Ben Naceur & Magda E. Kandil, 2013. "Basel Capital Requirements and Credit Crunch in the MENA Region," IMF Working Papers 13/160, International Monetary Fund.
    6. W. Bolt & A.F. Tieman, 2001. "When Basle II doesn't work: Contingency Rules versus Fixed Requirements," WO Research Memoranda (discontinued) 681, Netherlands Central Bank, Research Department.

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