Credit Market Competition and Capital Regulation

Credit Market Competition and Capital Regulation

Since intense competition occurs on credit market where good lending opportunities are in short supply, in author’s description, borrowers have gotten two valid tools to make banks monitoring, s.t. by requiring banks use some of their own capital in lending and allowing them to reap some of the benefits from the loans. Thus banks tend to hold higher level of capital and capital adequacy standards could be binding.

Bank’s capital structure affects the ability of attracting clients. The more capital a bank holds, the greater the loss the bank’s owner will face if the loan is not repaid and so the greater is the incentive to monitor, thus borrowers prefer to choose banks with higher level of capital. On the other hand, banks are incentivized to monitor because of firms are willing to make contracts under higher interest rate and allowing banks to reap some of the benefits from the loans. As banks’ monitor is increasing, the probability that firm’s loan is repaid increases, as well as the return on firm’s investments. As a consequence, agency problem between shareholders and managers can be resolved well.

The model in this paper is a simple one–period economy consisted by three parties: firms (borrowers), an arm’s length credit market (completely competition), and banks. The firm’s shareholders can choose between an arm’s length loan and a bank loan to finance the project. Market structure is set in two cases, NM.

At first, the author begins with the case where there is an excess demand for credit, which implies that there are fewer banks than investment projects (N

[pic 1]

subject to

[pic 2][pic 3]  [pic 4][pic 5];  0[pic 6][pic 7].

Specifically, [pic 8][pic 9] means bank’s monitoring effort, [pic 10][pic 11] and [pic 12][pic 13] mean rate for loan and deposit, separately; banks finance themselves with an amount of capital [pic 14][pic 15] at a cost [pic 16][pic 17] per unit, and an amount of deposits [pic 18][pic 19] at a cost [pic 20][pic 21], with [pic 22][pic 23]. [pic 24][pic 25] is a measure of the marginal cost of monitoring, and [pic 26][pic 27] means consumer surplus. [pic 28][pic 29] means gross payoff.