Credit Market Competition and Capital Regulation

CFS Working Paper No. 2005/23

Credit Market Competition and Capital Regulation*

Franklin Allen¹, Elena Carletti²,
and Robert Marquez³

September 24, 2005

Abstract:

Market discipline for financial institutions can be imposed not only from the liability side, as
has often been stressed in the literature on the use of subordinated debt, but also from the
asset side. This will be particularly true if good lending opportunities are in short supply, so
that banks have to compete for projects. In such a setting, borrowers may demand that banks
commit to monitoring by requiring that they use some of their own capital in lending, thus
creating an asset market-based incentive for banks to hold capital. Borrowers can also provide
banks with incentives to monitor by allowing them to reap some of the benefits from the
loans, which accrue only if the loans are in fact paid o.. Since borrowers do not fully
internalize the cost of raising capital to the banks, the level of capital demanded by market
participants may be above the one chosen by a regulator, even when capital is a relatively
costly source of funds. This implies that capital requirements may not be binding, as recent
evidence seems to indicate.

JEL Classification: G21, G38

Keywords: Banking, Costly Capital, Asset Side Market Discipline

* We would like to thank Martin Hellwig, Moshe Kim and Steven Ongena for useful comments, as well as seminar
participants at the Federal Reserve Bank of New York, the Max Planck Institute, the 2005 Federal Reserve Bank of Chicago
Bank Structure Conference, and the 2005 CEPR Summer Symposium. The usual disclaimers apply. We are grateful to the
Wharton Financial Instutions Center for financial support.

¹ Contact information: Franklin Allen, Wharton, School, University of Pennsylvania, 3620 Locust Walk, Philadelphia,
PA 19104-6367, [email protected].

² Center for Financial Studies

³ Robert H. Smith School of Business, University of Maryland at College Park

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