Ebook Credit Market Competition and Capital Regulation
A common justification for capital regulation for banks is the reduction of bank moral hazard. Given the presence of deposit insurance, banks have easy access to deposit funds. If they hold a low level of capital, there is an incentive for them to take on excessive risk. If the risky investment pays off, the banks’ shareholders receive the payoff. On the other hand, if it does not, the bulk of the losses are borne either by depositors or by the body providing deposit insurance. Given the widely accepted view that equity capital is more costly for banks than other forms of funds, the common assumption in much of the extant analyses of bank regulation is that capital adequacy standards should be binding as banks attempt to economize on the use of this costly input.
In practice, however, it appears that the amount of capital held by banks has varied substantially over time in a way that is difficult to explain as a function of regulatory changes. For example, Berger et al. (1995) report that in the 1840’s and 1850’s banks in the U.S. had capital ratios of around 40 to 50 percent. These ratios fell dramatically throughout the twentieth century, reaching a range of 6 to 8 percent in the 1940’s where they stayed until the end of the 1980’s. More recent evidence in Flannery and Rangan (2004) suggests that bank capital ratios have again increased, with banks in the U.S. now holding capital that is 75% in excess of the regulatory minimum (see also Barth et al., 2005, for international evidence). Given that capital adequacy standards were not in existence during much of the nineteenth century, and have not fluctuated much since their inception, it is hard to find a regulatory rationale to explain movements in banks’ capital holdings.
To better understand the role of bank capital and regulation, we present a simple model of bank lending that incorporates two features widely believed to be important for banking markets. First, we incorporate a consideration related to banks’ lending behavior into their choice of financing, recognizing that banks’ capital structures may have implications for their 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 shareholders 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.
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 liability problem banks face due to their extensive reliance on deposit-based financing.
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 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.(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.
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