review, see Flannery and Nikolova, 2004), but also from the asset side of the bank’s balance
sheet (see Kim et al., 2005, for evidence that borrowers may indeed exert a disciplinary
influence on banks’ behavior).
In this setting, we show that a regulator will in general want to choose a different level
of capital than that obtained in the market equilibrium. Specifically, when the cost of
equity capital is relatively low, and is just above the cost of deposits, the regulator will want
to impose a capital requirement that is above the level of capital obtained in the market.
This occurs for the same reason as above, in that the cost of deposit insurance is not fully
internalized by banks or borrowers. By contrast, when the cost of equity capital is high
relative to the cost of deposits, the regulator may want to impose a capital requirement that
is lower than that in the market. The reason is that the borrowers do not fully internalize
the cost of equity capital and demand a high level of capital as a commitment for banks to
monitor. In this instance, any capital requirement set by a regulator would not be binding,
because competition for borrowers leads banks to hold greater amounts of capital than is
socially optimal.
We extend our model to the case where there is no deposit insurance and show that the
qualitative results of the base model are unaffected. Specifically, banks may have incentives
to hold capital above what would be socially optimal when there is an excess supply of funds
and banks have to compete for borrowers. Interestingly, in the absence of deposit insurance,
banks may prefer to hold a positive level of capital even in the case where there is an excess
demand for credit as a way of reducing their cost of borrowing from depositors.
The implications of our model are consistent with recent empirical observations, including
the capital buildup of banks during the 90’s, when the competitiveness of credit markets is
thought to have increased significantly (for a discussion of this issue, see Boot and Thakor,
2000). Our model also offers the surprising prediction that, ceteris paribus, borrowers should
be willing to pay higher interest rates to less-capitalized banks in order to provide them an
alternative incentive to monitor. This is consistent with recent work by Hubbard et al.