ability to attract clients (e.g., borrowers). Second, we assume that banks perform a special
role as monitors or as producers of information. With these two features, we show that
costly capital is not a sufficient condition to guarantee that banks will minimize how much
capital they hold, implying that capital requirements need not be binding if banks operate in
a competitive market. Moreover, our model is static in nature, so we obtain this result even
abstracting from other, possibly important, dynamic considerations, such as those found in
Blum and Hellwig (1995), Bolton and Freixas (2005), or Peura and Keppo (2005).
The starting point of our model is that firms face an agency problem between sharehold-
ers and managers, which banks can help resolve by monitoring. Specifically, we assume that
the more monitoring a bank does, the greater is the probability that a firm’s investment is
successful. Bank monitoring therefore has two effects in our model. First, it increases the
probability that the firm’s loan is repaid, thus increasing the return to the bank. Second,
it benefits the firm’s owners since it increases the return on their investments. Firms there-
fore find bank loans more desirable the greater is the underlying agency problem between
shareholders and managers of the firm.2
Given limited liability for the bank, we argue that borrowers can use two different tools
to provide their lending bank with an incentive to monitor. One instrument is embodied
in the interest rate on the loan, since a marginal increase in the loan rate gives the bank
a greater incentive to monitor in order to receive the higher payoff if the project succeeds.
This increased payoff for the bank can also benefit the firm’s owners if it exceeds the extra
amount they pay the bank for the loan. A borrower can therefore use the interest payment
on the loan to pay for bank monitoring in a way that is contingent on the success of the
project. The second instrument is the amount of equity capital a bank has. The more capital
a bank holds, the greater the loss the bank’s owners will face if the loan is not repaid and
so the greater is the incentive to monitor. Put differently, capital helps solve the limited
2 There are numerous possible interpretations for bank “monitoring” that are consistent with our analysis.
For instance, banks may perform a screening function that allows them to better determine the likelihood of
loan repayment for individual borrowers. This screening should benefit borrowers by reducing cross-subsidies
and increasing the efficiency of loan pricing.