Credit Market Competition and Capital Regulation
Wharton Financial Institutions Center Working Paper No. 05-27
CFS Working Paper No. 2005/23
62 Pages Posted: 9 Oct 2005 Last revised: 26 Jan 2014
Date Written: January 13, 2008
It is commonly believed that equity finance for banks is more costly than deposits. This suggests that banks should economize on the use of equity and regulatory constraints on capital should be binding. Empirical evidence suggests that in fact this is not the case. Banks in many countries hold capital well in excess of regulatory minimums and do not change their holdings in response to regulatory changes. We present a simple model of bank moral hazard that is consistent with this observation. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to guarantee monitoring because it allows higher borrower surplus.
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