Credit Market Competition and Capital Regulation

manager’s agency problem and commit to a higher level of monitoring. Also, a bank loan
will be preferred if the arm’s length market is not very attractive (if rU is high relative to
rL).

To find the optimal level of monitoring for the banks, note that each of them chooses a
monitoring effort so as to maximize expected profits. Since the bank’s revenues is r_L - (1 -
k)rD if the loan is repaid and zero if the loan defaults, the expected profit can be expressed
as

max Π = q(r_L - (1 - k)r_D) - kr_E - cq².                      (4)

^q

The solution to this problem yields

q* = min ½ rL---(2c ^k)r^D , 1 ¾                            (5)

as the optimal level of monitoring for each bank. Note that, when q<1, bank monitoring
effort is increasing in the return from lending (rL) as well as in the level of capital (k) the
bank holds, but is decreasing in the deposit rate (rD )andinc, a measure of the marginal
cost of monitoring.

We note that this framework implies a moral hazard problem in the choice of monitoring
when banks raise a positive amount of deposits. Since banks repay depositors only when
their portfolios succeed, they do not internalize the full cost of default on depositors. This
limited liability biases bank monitoring downwards. Capital forces banks to bear some of the
burden associated with non-performing loans, and therefore provides an incentive for banks
to monitor. Thus, a possible rationale for regulation is to limit moral hazard and raise the
level of monitoring. This is illustrated by noting that, in the absence of limited liability, the
equilibrium level of monitoring would be qb =min rc^, 1} ≥ q*, with the inequality strict
whenever q* < 1. Since our focus is on bank monitoring and regulation, in what follows we
restrict attention to the case where firms find it optimal to borrow from a bank.

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