Credit Market Competition and Capital Regulation

from lending that the borrowers’ participation constraint is always satisfied when consumer
surplus is being maximized. We can now state the following result, which focuses on the
case of an interior solution for bank monitoring. The more general case is relegated to the
appendix.

q = R (1 ₄k—)^rD < 1. For c > ∣6r'2, banks earn zero expected profits, while for c < fif,
k^CS =1, and banks earn positive expected profits.

Proof: See the appendix, which contains a full characterization of the equilibrium. □

The results in Proposition 4 highlight the incentive mechanisms for bank monitoring
provided by a competitive credit market. There are two ways of providing banks with
incentives to monitor: by requiring that they hold a minimum amount of capital k^CS,and
by setting the rate rL on the loan so as to compensate them for their monitoring when the
project is successful and the loan is repaid. Both of these variables increase bank monitoring,
but differ in terms of their costs and their effects on consumer surplus and bank profits.
Borrowers would like banks to hold large amounts of capital so as to commit to exert a high
level of monitoring, as borrowers’ returns increase with q but they do not fully internalize
the costs of capital and of monitoring. By contrast, since capital is a costly input (i.e.,
r_E ≥ r_D), banks would prefer to minimize its use and to instead receive incentives through
a higher loan rate, rL . However, while increasing rL is good for incentive purposes, its direct
effect is to reduce the surplus to the borrowers. Raising r_L will therefore eventually reduce
borrower surplus, and this occurs when the positive incentive effect of a higher loan rate on
bank monitoring is dominated by the negative direct effect on consumer surplus, R - rL.
Thus, when borrowers obtain the surplus, banks have to raise a positive amount of capital
to attract borrowers.

14

<<   <   14   15   16   17   18   19   20   >   >>