Credit Market Competition and Capital Regulation

be beneficial as it increases social welfare relative to what would be obtained under the
market solution. In these instances, there is a rationale for capital regulation as a way of
providing banks with incentives to monitor.

5 Excess supply of funds

We now turn to the case where there is a shortage of good lending opportunities for banks
relative to the funds the banking system has available to lend. In this case, banks will have
to set contract terms competitively in order to attract borrowers, who will generally be able
to appropriate most, if not all, of the surplus associated with their projects. In contrast to
the previous section, this case reflects the situation where there are fewer investment projects
than banks (M<N).

The capital holdings and interest rate that maximize borrower surplus solve the following
problem:

max CS = q (R - rL)                            (8)

k,rL

subject to

rL - (1 - k)rD

q = mini------2c------, 1∫;

Π = q(r_L - (1 - k)r_D) - kr_E - cq² ≥ 0;

0 ≤ k≤1;

1 ≤ rL ≤ R;

where, as before, Π represents bank profits, q is the monitoring effort that each bank chooses
as a function of r_L and k, and CS represents consumer surplus. Note that, in contrast to the
previous section, we now impose a participation constraint for banks, in that they must earn
non-negative profits, and a constraint that the loan rate not be higher than the maximum
return from the project. We will assume throughout that there is enough surplus generated

13

<<   13   14   15   16   17   18   19   >>

More intriguing information