Competition and Entry in Banking: Implications for Capital Regulation

1. Competition and Entry in Banking: Implications for Capital Regulation Arnoud W.A. Boot University of Amsterdam and CEPR Matej Marinč University of Ljubljana and University of Amsterdam

2. Motivation / Questions • Does costly capital regulation induce more or less entry? • Does competition induce more risk (instability)? • When competition induces more risk, does raising capital help? • Should the regulator be reluctant to opening up borders of domestic banking markets?

3. New Perspective The literature on bank competition has mainly focused on symmetric banks • We recognize the importance of fixed costs associated with monitoring • Banks differ with respect to effectiveness of monitoring technology • Market share and scale are now important

4. Key Insights • Can more stringent (costly) capital regulation induce more entry? • IT CAN!!! • Higher capital can be value enhancing because it limits distortions of deposit insurance • Capital regulation is less effective when needed the most  for bad banks • Competition makes capital regulation even less effective for bad banks

5. Model Details I Y 1 • Borrowers • Banks invest in monitoring technology - good banks, costs are - bad banks, costs are • Monitoring • increases borrower’s success probability • increases bank’s profitability 0

6. Model Details III - Competition • At t=1, each borrower is matched with incumbent bank, receives offer • At t=2, each borrower searches for second offer • w.p. [1-q] no second offer loan; accepts monopolistic interest rate of incumbent bank • w.p. q receives second offer; both banks compete as Bertrand competitors • q is measure of competition as is N • Incumbent bank has an incumbency advantage S (hence switching cost is S)

7. Time Line Payoffs are realized. 1 0 2 3 Dates • The regulator sets the capital requirement. • Banks enter the banking industry (if applicable). • Each borrower is matched with a bank. • Each bank discovers its type. • Banks invest in monitoring technology. • Each borrower gets an initial offer from his bank. • Each borrower searches for a competing bank. • If a second bank materializes, the incumbent bank and the ‘second bank’ compete as Bertrand competitors. If no second bank is available, only the borrowers’s first offer is available. • Each bank collects the necessary capital and deposits, and funds its borrowers. • Borrowers undertake their projects.

8. Results: No Entry I Higher competition (higher q) • negatively affects the effectiveness of the capital requirements for bad banks • but it increases the effectiveness of capital regulation for good banks

9. Results: No Entry II • Higher capital requirements • always reduce the value of a bad bank • BUT increase the value of good bank as long as • competition is sufficiently strong (high q) • the quality of banking industry is sufficiently low (low )

10. Entry: Main result • When competition is low higher capital requirements decrease entry • When competition is high higher capital requirements (a) increase entry for intermediate quality of banking system • (b) decrease entry for low or high quality of banking system

11. Key insight • Capital requirements have a cleansing effect on the industry • Strong support for Basel I • There is an intricate link between competition and stability, with a clear asymmetry between low and high quality banking systems