Working Paper: CEPR ID: DP5518
Authors: Arnoud W. A. Boot; Matej Marinc
Abstract: We assess the influence of competition and capital regulation on the stability of the banking system. We particularly ask two questions: i) how does capital regulation affect (endogenous) entry; and ii) how do (exogenous) changes in the competitive environment affect bank monitoring choices and the effectiveness of capital regulation? Our approach deviates from the extant literature in that it recognizes the fixed costs associated with banks? monitoring technologies. These costs make market share and scale important for the banks? cost structures. Our most striking result is that increasing (costly) capital requirements can lead to more entry into banking, essentially by reducing the competitive strength of lower quality banks. We also show that competition improves the monitoring incentives of better quality banks and deteriorates the incentives of lower quality banks; and that precisely for those lower quality banks competition typically compromises the effectiveness of capital requirements. We generalize the analysis along a few dimensions, including an analysis of the effects of asymmetric competition, e.g. one country that opens up its banking system for competitors but not vice versa.
Keywords: banking; capital regulation; competition
JEL Codes: G21; L13; L50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Capital regulation (G28) | Entry of banks (G21) |
| Competition (L13) | Monitoring incentives of higher quality banks (G21) |
| Competition (L13) | Monitoring incentives of lower quality banks (G21) |
| Competition (L13) | Effectiveness of capital regulation (G28) |
| Higher capital requirements (G28) | Entry of banks (G21) |
| Increased competition (L13) | Capital regulation effectiveness for lower quality banks (G28) |