Capital requirements and competition in banking industry
This paper focuses on the interaction between regulation and competition in an industrial organisation model. We analyze how capital requirements affect the profitability 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 effort to reduce loan losses so as to maximize profits. From the regulator's point of view, the free market solution is not optimal as private banks do not take in to account the consumer surplus and the social cost of bankruptcy (financial stability aspects). It is show that capital requirements may improve welfare, even under conditions that both banks would ever 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 bankruptcy, capital requirements are particularly welfare improving.
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- Arnoud Boot & Silva Dezõelan & Todd Milbourn, 1999. "Regulatory Distortions in a Competitive Financial Services Industry," Journal of Financial Services Research, Springer, vol. 16(2), pages 249-259, December.
- Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, June.
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- Bhattacharya, Sudipto & Boot, Arnoud W A & Thakor, Anjan V, 1998.
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Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 30(4), pages 745-70, November.
- David A. Marshall & Edward S. Prescott, 2000.
"Bank capital regulation with and without state-contingent penalties,"
Working Paper Series
WP-00-10, Federal Reserve Bank of Chicago.
- Marshall, David A. & Prescott, Edward Simpson, 2001. "Bank capital regulation with and without state-contingent penalties," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 139-184, June.
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