Credit Market Competition and Capital Regulation

by Jim Naughton, for The Harvard Law School Forum at Harvard Law School, December 11, 2009.

In our paper, Credit Market Competition and Capital Regulation, which was recently accepted for publication in the Review of Financial Studies, we present a theory that demonstrates that inducements for banks to hold capital can also come from the asset side. We show that when credit markets are competitive, market discipline coming from the asset side induces banks to hold positive levels of capital as a way to commit to monitor and attract borrowers.

We develop a simple one-period model of bank lending, where firms need external financing to make productive investments. Banks grant loans to firms and monitor them, which helps improve firms’ expected payoff. Given that monitoring is costly and banks have limited liability, banks are subject to a moral hazard problem in the choice of monitoring effort. One way of providing them with greater incentives for monitoring is through the use of equity capital. This forces banks to internalize the costs of their default, thus ameliorating the limited liability problem banks face due to their extensive reliance on deposit-based financing. A second instrument to improve banks’ incentives is embodied in the loan rate. A marginal increase in the loan rate gives banks a greater incentive to monitor in order to receive the higher payoff if the project succeeds and the loan is repaid. Thus, capital and loan rates are alternative ways to improve banks’ monitoring incentives, but entail different costs. Holding capital implies a direct private cost for the banks, whereas increasing the loan rate has a negative impact only for borrowers in terms of a lower return from the investment. We consider both the case where there is and isn’t deposit insurance…(continue reading)

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