Incentive-Based Lending Capacity, Competition and Regulation in Banking

Abstract

This paper studies banks' moral hazard stemming from delegated monitoring in an environment of aggregate risk. It explores its feedback on interbank competition and credit market equilibrium both within an unregulated and an (optimally) regulated banking system. It provides a theory based on incentives to explain bank's lending capacity, banks' profit margins and firms' cost of capital, linking them to business cycles and the structure of the credit sector. It provides a theory of banks' optimal capital requirements. We show that socially optimal capital requirements are lower in recessions than in booms, and are higher the less concentrated is the banking sector and the less segmented are credit markets. These results may explain the cyclical behavior of banks' profit margins and firms' cost of capital, 'forbearance' by regulators during recessions and the increased focus on bank capital regulations that accompanied the recent removal of entry barriers in banking both in the U.S. and in Europe.

JEL Classification: G21