1 Competition and Entry in Banking: Implications for Capital Regulation by Arnoud W. A. Boot and Matej Marenč Discussant: Franklin Allen JFI/WB Conference on Bank Regulation and Corporate Finance

2 The Model Banks financed with equity and deposits Cost of equity > Cost of insured deposits Regulatory capital minimum k binds Banks monitor borrowers – the more monitoring the higher is v, the borrower’s probability of high payout Cost of monitoring = (c/2)(v-v T ) 2 with v G >v B

3 The Model (cont.) t=0t=1t=2t=3 -k set by-Borrower -Borrower-Payoffs regulator matchedsearches forrealized with bankcompeting offer -Banks-Bank type-Prob. q one entergood or bad appears and there discovered is Bertrand comp. -Bank makes-Funds collected first offer -Borrowers do projects

4 Main Results With a fixed number of banks, increasing competition (a higher q) improves the monitoring incentives of good banks and reduces those of bad banks With endogenous entry, increasing capital requirements increases the returns to good banks and reduces the returns to bad banks so there is a “cleansing” effect In weak banking systems capital regulation is less effective than in strong banking systems

5 Comments Model is very interesting and much can be done with it More discussion on the nature of fixed costs helpful Policy analysis is focused on level of monitoring and thus on stability issues A welfare analysis would be helpful –What is the optimal number of banks? –What are the set of efficient allocations? –Is a reduction in risk always desirable? –What is the optimal value of k?

6 Comments (cont.) What is the size distribution of firms in the solution? Symmetric equilibria are considered but asymmetric equilibria may also be important It would be good to prove that the minimum capital constraint k imposed by the regulator is binding

7 Comments (cont.) Given a fixed cost of monitoring, would a two part pricing scheme for loans allow an improvement? What would happen without deposit insurance? Can the results on foreign entry be related to what happened in Eastern Europe?