Credit Market Competition and Capital Regulation

3 Financing choice and bank monitoring

Before proceeding to the main analysis, it is useful to characterize the borrowers’ choice of
financing source, as well as the banks’ choice of monitoring effort taking as given the amount
of capital, k, and the pricing of the loans, rL. With an unmonitored (i.e., arm’s length) loan,
the manager of each firm chooses effort E to maximize

max ∏a = E (R - ru) + (1 - E) B - ^~,
E2

where rU is the interest rate on an unmonitored loan. The solution to this problem yields

E* = max {R — ru — B, 0} ,                         (2)

with the additional condition that E ≤ 1. Note that the manager’s effort is decreasing in
both the private benefit B and the loan rate rU . The manager exerts the maximal effort
E * = R — r_u for B = 0, and reduces it as B increases. Similarly, E → 0 as r_u → R — B <R.

The firm chooses the source of financing that maximizes its value. That is, the firm
chooses to obtain a bank loan as long as the return, q(R — r_L), is greater than if the loan is
unmonitored, E(R — rU). This can be expressed as

q(R— rL) > (R — rU — B)(R — rU)

or

B > R — ru - q (R - ^rL).                          (3)

(R—rU)

Condition 3 shows that the choice between an unmonitored loan from the arm’s length
market and a monitored loan from a bank depends on the level of private benefit for the
manager as well as the loan rates. Firms where managers have large private benefits, so that
there is a severe agency problem, will prefer to borrow from banks as a way to solve the

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