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 BorrowersY
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

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 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.

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