a higher interest rate on the loan, and so borrowers should just require the lowest possible
interest rate consistent with q =1, which is satisfied by rL =(1- k)rD +2c.Ifweagain
substitute this value of rL into the expression for bank profits we obtain
Π = (rL - (1 - kcS)rD) - kcSrE - c = c - kcSrE,
which, after setting equal to zero, yields kcS = ɪ as long as c < rE. In this case, we have
rL =(1
rE )rD + 2c = ( rE-c )rD + 2c.
Otherwise, for c>rE, kcS =1, which implies that rL =2c. Moreover, substituting this
value of rL into q = min ∣rL-(1-k——, 1} and observing that kcS = 1, we obtain that Π > 0
and q = min 4R-,c, 1} = 1 for R ≥ 4c, and is less than 1 otherwise. All together, this implies
that q ≥ 1 for R ≥ 4c, and q < 1 for R < 4c. □
Proposition 5B When there is an excess supply of funds, capital regulation that maximizes
social welfare requires:
1) For R > 2c2rE-D
rD
monitoring is q = min {R, 1}, and capital equals kreg =
min{ , 1},
which is less than 1 for R>4c and equal to 1 otherwise.
2) For R < 2c2-e---d, monitoring is q = R-(1-k—rD < 1 and capital equals kreg =
RrD +rD2 -8c(rE -rD)
min(-----D-rD-------,1;
which is less than 1 for R < 8c(rE-rD) and equal to 1 otherwise.
Proof: Start by maximizing social welfare with respect to k, assuming that the loan rate is
set to maximize CS, i.e., that rL = R+(12 k)-D. Social welfare is given by
maxSW =Π+CS- (1-q)(1- k)rD =qR- (1- k)rD - krE - cq2.
k
We can now take the first order condition to get
∂SW ∂q
ɪ" = ɪ (R - 2cq) - rE + rD.
∂k ∂k
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