Credit Market Competition and Capital Regulation

Empirical evidence suggests that banks hold capital in excess of regulatory minimums. This did not prevent the financial crisis and underlines the importance of understanding bank capital determination. Market discipline is one of the forces that induces banks to hold positive capital. The literature has focused on the liability side. We develop a simple theory based on monitoring to show that discipline from the asset side can also be important. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to commit to monitoring because it allows higher borrower surplus.