liability problem banks face due to their extensive reliance on deposit-based financing.3
We consider two distinct cases regarding the structure of the credit market in our analysis.
In the first case, we assume that the demand for loans by firms with good projects exceeds
banks’ supply of funds so that borrowers must compete for funds. In the second case, we
assume instead that there is a shortage of good projects relative to the funds available so
that banks must compete for firms’ business and tailor their contracts so as to attract this
business.
When there is a shortage of bank funds available, we show that banks optimally choose to
hold no capital since equity is more costly than deposits, and limited liability protects them
from having to repay depositors when their loans are not repaid. Banks also raise the interest
rates on loans to the highest level that is consistent with firms being willing to borrow, and
it is this which provides them with an incentive to monitor. We also show that when the
cost of equity is not too much greater than the cost of deposits, a regulator interested in
maximizing social welfare would impose a requirement that banks hold a positive amount of
capital. This “capital requirement” leads to improved monitoring and reduces the cost to
the deposit insurance fund, an aspect which is not internalized by the banks. The banks,
however, would like to have as low a level of capital as possible so that any capital constraint
imposed by a regulator will be binding.
The case where there is an excess supply of bank funds is more complex. In equilibrium,
we find that even in the absence of a regulator, banks will hold a positive amount of capital
in order to attract borrowers’ business. The reason is that capital acts as a commitment
device for banks to monitor, which is good for borrowers. Moreover, we also find that the
loan rate most attractive to borrowers is also one that is sufficiently high to induce banks
to monitor. These findings suggest that market discipline can be imposed not only from the
liability side, as has been stressed in the literature on the use of subordinated debt (for a
3 Following the rest of the literature on capital regulation, in the first part of the paper we take it as given
that there is deposit insurance. We relax this assumption in the later part of the paper to show that our
results are not driven by the existence of deposit insurance.