(2002), who find that borrowing from poorly-capitalized banks is more expensive, but only
for informationally-sensitive borrowers (see also Kim et al., 2005). Moreover, our model offers
other cross-sectional implications concerning firms’ sources of borrowing. An implication of
our analysis is that borrowing from a well-capitalized bank that thus commits to monitoring,
is of greater value to firms with high agency problems. Firms for which monitoring adds little
value should prefer to borrow either from an arm’s length source of financing or from a bank
with low capital. Billett et al. (1995) finds that lender “identity,” in the sense of the lender’s
credit rating, is an important determinant of the market’s reaction to the announcement of
a loan. To the extent that capitalization improves a lender’s rating and reputation, these
results are in line with the predictions of our model.
Recent research on the role of bank capital has studied the interaction between capital
and liquidity creation (Diamond and Rajan, 2000) and the role of capital in determining
banks’ lending capacities and providing incentives to monitor (Holmstrom and Tirole, 1997).
Our approach is complementary to these, but instead focuses on how borrower demand for
monitoring services can itself lead banks to hold capital. Our paper is also related to studies
of the role of capital in reducing risk-taking, recent examples of which are Hellmann et al.
(2000) and Repullo (2004).
Section 2 outlines the model. Section 3 considers firms’ financing choice and banks’ choice
of monitoring taking the loan rates and capital amounts as given. The case where there is
an excess demand for credit is considered in Section 4, while the case where there is an
excess supply of funds is analyzed in Section 5. Section 6 extends the analysis to the case
where there is no deposit insurance, and where banks can engage in risk-shifting via their
monitoring decisions. Section 7 contains concluding remarks.