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Banking competition, risk, and regulation

  • W. Bolt
  • A. F. Tieman

In a dynamic framework banks compete for customers by setting lending conditions for the loans they supply, taking into account the capital adequacy requirements posed by the regulator. By easing its lending conditions a bank faces a tradeoff between attracting more demand for loans, thus making higher per-period profits, and a deterioration of the quality of its loan portfolio, thus a higher risk of failure. Our main results state that more stringent capital adequacy requirements lead commercial banks to set more stringent loan conditions to their customers, and we show that increased competition in the banking industry leads banks to behave more risky. In this model we also look at risk-adjusted capital requirements and show that risk-based regulation is effective. We extend the basic model to have banks choose both their lending conditions and the level of bank capital. In this extended model it turns out that it may be beneficial for a bank to hold more equity than prescribed by the regulator, even though equity is more expensive than attracting deposits. We show that the same conclusions with respect to the effectiveness of regulation hold as in the standard model.

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Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 647.

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Date of creation: 2001
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Handle: RePEc:dnb:wormem:647
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Web page: http://www.dnb.nl/en/

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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 745-70, November.
  2. Petersen, Mitchell A & Rajan, Raghuram G, 1995. "The Effect of Credit Market Competition on Lending Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 407-43, May.
  3. Perotti, Enrico C & Suarez, Javier, 2001. "Last Bank Standing: What Do I Gain if You Fail?," CEPR Discussion Papers 2933, C.E.P.R. Discussion Papers.
  4. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, June.
  5. Matutes, Carmen & Vives, Xavier, 1995. "Imperfect Competition, Risk Taking, and Regulation in Banking," CEPR Discussion Papers 1177, C.E.P.R. Discussion Papers.
  6. Jokivuolle, Esa & Kauko, Karlo, 2001. "The New Basel Accord: some potential implications of the new standards for credit risk," Research Discussion Papers 2/2001, Bank of Finland.
  7. Joe Peek & Eric Rosengren, 1991. "The capital crunch: neither a borrower nor a lender be," Working Papers 91-4, Federal Reserve Bank of Boston.
  8. Eduardo Levy Yeyati & Tito Cordella, 1997. "Public Disclosure and Bank Failures," IMF Working Papers 97/96, International Monetary Fund.
  9. Peter J.G. Vlaar, 2000. "Capital requirements and competition in banking industry," Working Paper Series WP-00-18, Federal Reserve Bank of Chicago.
  10. Stephen F. LeRoy, 1990. "Mutual deposit insurance," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jun8.
  11. C. H. Furfine, 2000. "Evidence on the response of US banks to changes in capital requirements," BIS Working Papers 88, Bank for International Settlements.
  12. Gary Gorton & Andrew Winton, 1995. "Bank Capital Regulation in General Equilibrium," NBER Working Papers 5244, National Bureau of Economic Research, Inc.
  13. Skander Van den Heuvel, 2006. "The Bank Capital Channel of Monetary Policy," 2006 Meeting Papers 512, Society for Economic Dynamics.
  14. Chu, Kam Hon, 1999. "Free Banking and Information Asymmetry," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(4), pages 748-62, November.
  15. P.J.G. Vlaar, 2000. "Capital requirements and competition in the banking industry," WO Research Memoranda (discontinued) 634, Netherlands Central Bank, Research Department.
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