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Competition and Entry in Banking: Implications for Capital Regulation

by

Arnoud W. A. Boot and Matej Marenč

Discussant: Franklin Allen

JFI/WB Conference on Bank Regulation and Corporate Finance

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The Model

• Banks financed with equity and deposits

• Cost of equity > Cost of insured deposits

• Regulatory capital minimum k binds

• Banks monitor borrowers – the more monitoring the higher is v, the borrower’s probability of high payout

• Cost of monitoring = (c/2)(v-vT)2 with vG>vB

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The Model (cont.)

t=0 t=1 t=2 t=3

-k set by -Borrower -Borrower -Payoffsregulator matched searches for realized

with bank competing offer-Banks -Bank type -Prob. q one enter good or bad appears and there

discovered is Bertrand comp.-Bank makes -Funds collectedfirst offer -Borrowers do

projects

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Main Results

• With a fixed number of banks, increasing competition (a higher q) improves the monitoring incentives of good banks and reduces those of bad banks

• With endogenous entry, increasing capital requirements increases the returns to good banks and reduces the returns to bad banks so there is a “cleansing” effect

• In weak banking systems capital regulation is less effective than in strong banking systems

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Comments

Model is very interesting and much can be done with it

• More discussion on the nature of fixed costs helpful

• Policy analysis is focused on level of monitoring and thus on stability issues

• A welfare analysis would be helpful– What is the optimal number of banks?– What are the set of efficient allocations?– Is a reduction in risk always desirable?– What is the optimal value of k?

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Comments (cont.)

• What is the size distribution of firms in the solution?

• Symmetric equilibria are considered but asymmetric equilibria may also be important

• It would be good to prove that the minimum capital constraint k imposed by the regulator is binding

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Comments (cont.)

• Given a fixed cost of monitoring, would a two part pricing scheme for loans allow an improvement?

• What would happen without deposit insurance?

• Can the results on foreign entry be related to what happened in Eastern Europe?