Competition and Entry in Banking: Implications for Capital Regulation

Transcription

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 1

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? 2

3 New Perspective The literature has mainly focused on symmetric banks. Real world s s concerns are very much about how capital requirements work in heterogeneous industry We recognize the importance of fixed costs associated with the banks monitoring technology. This makes scale and hence (anticipated) market share crucially important 3

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 4

5 Relevant Literature Effect of capital regulation Hellman,, Murdock & Stiglitz (2000), Repullo (2004), Allen, Carletti & Marquez (2005), Effect of competition on the nature of intermediation Petersen & Rajan (1994), Boot & Thakor (2000) Effect of competition on stability Keeley (1990), Vives(2001), Boyd & de Nicolo (2005) Corporate finance IO literature Brander & Lewis (1986), Maksimovic (1995) 5

6 Borrowers Model Details I 1 Banks invest in monitoring technology - good banks, costs are - bad banks, costs are Y 0 Monitoring increases borrower s s success probability increases bank s s profitability 6

7 Model Details II - Funding Each bank funds with k bank capital and [1-k] deposits. Deposits are insured. Demand a return r D Capital is costly, cost of capital is ρ>r D Capital requirements dictate level of capital in the industry Both capital requirement and deposit insurance flat 7

8 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) 8

9 Time Line Dates Payoffs are realized 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 borrower's first offer is available. Each bank collects the necessary capital and deposits, and funds its borrowers. Borrowers undertake their projects. 9

10 Separating Nash Equilibrium Banks of the same type choose the same level of monitoring technology Good banks grab market share Bad banks lose market share Good banks decide for higher monitoring due to lower costs and higher market share Bad banks decide for lower monitoring due to higher costs and lower market share Conditions on the incumbency advantage: 10

11 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 11

12 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 ) 12

13 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 13

14 Extension I: One Sided Competition One-sidedly opening up borders harms bad banking system bad banks lose market share, as a result they cut back on monitoring (and become more risky) Bad banks have higher merger incentives than good banks to prevent losing market share to foreign entry Higher capital requirements could augment the profitability of entering a weak banking market 14

15 Empirical Predictions I Increasing the openness/competition measure q shifts market share from bad to good banks Increasing openness q undermines stability in a low quality banking market but strengthens it in high quality banking markets The effectiveness of capital regulation is negatively affected by competition (q)( ) for low quality banks but not so for high quality banks 15

16 Empirical Predictions II Strengthening capital requirements encourages entry in banking markets that are of intermediate quality and sufficiently competitive (high q) Increasing the number of players N in the industry reduces investments in monitoring technology and the effectiveness of capital regulation for all banks Strengthening capital requirements helps existing banks enter weak foreign banking markets and also encourages (late) entry by de novo banks The threat of foreign entry encourages mergers between domestic institutions in weak banking systems, but not in high quality banking systems 16

17 Conclusions We see heterogeneity in quality and fixed costs as key characteristics of the banking industry 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 17