Bank competition and the role of regulation

Market discipline for financial institutions can be imposed not only from the liability side, as has often been stressed in the literature on the use of subordinated debt, but also from the asset side. This will be particularly true if good lending opportunities are in short supply, so that banks have to compete for projects. In such a setting, borrowers may demand that banks commit to ?monitoring? by requiring that they use some of their own capital in lending, thus creating a market-based incentive for banks to hold capital that stems purely from the asset side of the bank?s balance sheet. Borrowers can also provide a bank with incentives to monitor by allowing the bank to reap some of the benefits from the loan, which accrue only if the loan is in fact paid off. Since borrowers do not fully internalize the costs of capital to the bank and of the deposit insurance, the level of capital required by the market may be above the one chosen by a regulator maximizing social welfare. This implies that capital requirements may not be binding.