Credit Market Competition and Capital Regulation

banks obtain it and, therefore, the regulator has to use more capital to provide banks with
incentives to monitor. Optimal regulation, however, does not necessarily call for “narrow
banking” in the sense of having fully capitalized intermediaries, but rather allows for a mix
between capital and deposit-based financing. This will generally be true when the cost of
capital relative to deposits, r_E - r_D , is high, or when the aggregate return from encouraging
greater monitoring, R, is relatively low.

We now turn to one of the main results in the paper, which is whether a pure market-
based system is likely to provide sufficient incentives for bank discipline and monitoring, and
whether capital regulation can be an effective tool for providing such incentives. For that,
we have the following:

Proposition 6 For all R, r_E, and c, there exists a value re_D (R, r_E,c) > 0 such that k^reg <
k^CS for rD < reD , and k^reg ≥ k^CS for rD ≥ reD .

Proof: See the appendix. □

While the exact expressions for reD are provided in the proof, the interpretation of this
result can be stated quite generally for all parameter values as follows. When capital is much
more expensive than deposits (rD << rE), it is socially optimal to economize on capital
and instead rely more heavily on deposits for financing the bank. The market solution, by
contrast, will demand that banks hold an excessive level of capital when there is a shortage of
good lending opportunities and credit markets are competitive. At the other extreme, when
bank capital is not significantly more costly than deposits, regulators desire that banks hold
more capital than the market requires. The reason is that the regulator internalizes both
the cost of raising capital as well as the cost to the deposit insurance fund. Thus, when
the difference rE - rD is high, the regulator chooses to impose a lower capital requirement
because capital is socially more costly than repaying depositors in case of bank default. By
contrast, when the difference r_E - r_D is low, the regulator prefers to require a high level of
capital and reduce the costs of bank default.

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