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

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?

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

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

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

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)

Time Line 1 2 3 Dates Payoffs are realized. 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.

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

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 )

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

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