Competition and Entry in Banking: Implications for Capital Regulation

1
Competition and Entry in Banking Implications
for Capital Regulation

• Arnoud W.A. Boot
• University of Amsterdam and CEPR
• Matej Marinc
• University of Ljubljana and University of
  Amsterdam

2
Motivation / Questions

• Does costly capital regulation induce more or
  less entry?
• Does competition induce more risk (instability)?
• When competition induces more risk, does raising
  capital help?
• Should the regulator be reluctant to opening up
  borders of domestic banking markets?

3
New Perspective

• The literature on bank competition has mainly
  focused on symmetric banks
• We recognize the importance of fixed costs
  associated with monitoring
• Banks differ with respect to effectiveness of
  monitoring technology
• Market share and scale are now important

4
Key Insights

• Can more stringent (costly) capital regulation
  induce more entry?
• IT CAN!!!
• Higher capital can be value enhancing because it
  limits distortions of deposit insurance
• Capital regulation is less effective when needed
  the most ? for bad banks
• Competition makes capital regulation even less
  effective for bad banks

5
Model Details I
Y

• Borrowers
• Banks invest in monitoring technology - good
  banks, costs are - bad banks, costs are
• Monitoring
• increases borrowers success probability
• increases banks profitability

1
0
6
Model Details III - Competition

• At t1, each borrower is matched with incumbent
  bank, receives offer
• At t2, each borrower searches for second offer
• w.p. 1-q no second offer loan accepts
  monopolistic interest rate of incumbent bank
• w.p. q receives second offer both banks compete
  as Bertrand competitors
• q is measure of competition as is N
• Incumbent bank has an incumbency advantage S
  (hence switching cost is S)

7
Time Line
Payoffs are realized.
1
0
3
2
Dates

• The regulator sets the capital requirement.
• Banks enter the banking industry (if applicable).

• Each borrower is matched with a bank.
• Each bank discovers its type.
• Banks invest in monitoring technology.
• Each borrower gets an initial offer from his bank.

• Each borrower searches for a competing bank.
• If a second bank materializes, the incumbent bank
  and the second bank compete as Bertrand
  competitors. If no second bank is available, only
  the borrowerss first offer is available.
• Each bank collects the necessary capital and
  deposits, and funds its borrowers.
• Borrowers undertake their projects.

8
Results No Entry I

• Higher competition (higher q)
• negatively affects the effectiveness of the
  capital requirements for bad banks
• but it increases the effectiveness of capital
  regulation for good banks

9
Results No Entry II

• Higher capital requirements
• always reduce the value of a bad bank
• BUT increase the value of good bank as long as
• competition is sufficiently strong (high q)
• the quality of banking industry is sufficiently
  low (low )

10
Entry Main result

• When competition is low higher capital
  requirements decrease entry
• When competition is high higher capital
  requirements (a) increase entry for intermediate
  quality of banking system
• (b) decrease entry for low or high quality of
  banking system

11
Key insight

• Capital requirements have a cleansing effect on
  the industry
• Strong support for Basel I
• There is an intricate link between competition
  and stability, with a clear asymmetry between low
  and high quality banking systems