The exact amounts of monitoring and capital in equilibrium depend on the return of
investment projects R, the cost of capital rE , and the cost of monitoring c. When projects
are not very profitable (R<4c) but capital is not too costly (rE <c), banks raise the
highest level of capital, but do not monitor fully since the cost of doing so would be too
high. If capital is relatively costly, however, so that rE >c, market incentives lead banks to
choose a lower level of capital (kCS < 1), less monitoring (q<1), or both. The participation
constraint of banks prevents them from raising the highest level of capital, thus leading to
a lower level of monitoring. In the appendix, we also present the case where projects are
highly profitable (R ≥ 4c), and show that, when capital is not too costly, banks exert the
maximum effort, q =1, and raise the highest level of capital, kCS =1. Borrowers want banks
to monitor fully as projects are very profitable, and can induce banks to do so by raising
only capital, as long as this is not too costly and banks’ profits are positive. When capital
is costly, however, banks will again choose a lower level of capital and/or less monitoring.
Interestingly, borrowers may be willing to give up some of the return on the loans to
the banks in order to provide them with incentives to monitor. They accomplish this by
allowing the loan rates to reflect the returns of the projects, and to be increasing in such
returns as long as there are incentive effects from doing so (as long as q < 1): d∂RL > 0. In
other words, the loan’s price need not be set only to compensate banks for the credit risk
associated with granting the loan, but also to induce them to exert effort in monitoring the
projects and thus improve the expected returns of the loans. Furthermore, since capital and
loan rates are alternative instruments for providing banks with an incentive to monitor, we
note that the equilibrium value of rL is decreasing in the level of capital k. This implies
that these are substitute instruments from the point of view of borrowers, who only trade
off their relative costs from the perspective of reducing consumer surplus. The findings in
Hubbard et al. (2002) and Kim et al. (2005) lend support to this result, in that they find
that interest rates are higher on loans from less-capitalized banks.
The complement to Proposition 2 from the previous section is to analyze the optimal
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