Credit Market Competition and Capital Regulation



To maximize social welfare in the absence of deposit insurance, we need to solve

max SW = Π + CS = qR - (1 - k) rD - krE - cq2.
k

The FOC yields

∂SW  ∂q

-ɪ- = W (R 2cq) + γd - ге = 0.
∂k    ∂k

Using dq = I     rD       , we can substitute into the FOC and solve for k, which yields

∂k      16ckrD -16crD +R2

1 18crD 48crD rE + 32crD r2E + 3R2γd rE 2R2r2E

2                crD (4ге3rD)2

Comparing these two solutions, we note that as rD 0, we have that, as before, kCS
16Rr^. By contrast, for the case of social welfare maximization it is easy to see from the
FOC that as r
D 0, kreg 0 as well. Therefore, for rD sufficiently small, we have that
k
reg kCS, as desired.

Proof of Proposition 8: Note that bank profit maximization with respect to k yields the
following FOC:

dq (rL (1 - k)cD) + qcD - q(1 k)dcD
∂k                            ∂k

9 dq

Ге2cq^r
∂k


qcD Геq(1 k) ɪ.

∂k

Since qcD = γd, dCqD = rD, and, given q = ɪ RR + RR2 8d (1 k) J when γl = RrB,

that dq = l rD      > 0, the FOC becomes :

dk    λ∕R2-8crD (1-k)     ’

rD         rD

ΓD Ге + (1 k)--.                  = 0.

q pR2 8crD (1 k)

Evaluating at k = 0, is clearly positive for rD rE. Substituting in for q, we can find

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