Capital requirements, market power, and risk-taking in banking

Abstract

This paper presents a dynamic model of imperfect competition in banking where the banks can invest in a prudent or a gambling asset. We show that if intermediation margins are small, the banks' franchise values will be small, and in the absence of regulation only a gambling equilibrium will exist. In this case, capital requirements can ensure the existence of a prudent equilibrium, because they do not affect the banks' franchise values and reduce their gambling incentives by putting their equity at risk. In contrast, deposit interest rate ceilings may increase the banks' franchise values, but do not always guarantee the existence of a prudent equilibrium.

Bank Size and Risk-Taking under Basel II

“…Equity finance is inefficient, but it may be used for regulatory purposes. Such an assumption has become standard in the literature (see e. g. Hellmann, Murdoch, and Stiglitz (2000) and Repullo (2004)). We assume that depositors cannot observe the amount of equity taken in by their bank, so that banks cannot use their equity as a signal for project quality.…”

“…This has been done, for example, by Repullo (2004) in a more sophisticated way (see also Hellmann, Murdoch, and Stiglitz (2000)). Instead we employ a simple framework that yields reasonable predictions on the effects of capital regulation; then we analyze the effect of the coexistence of the standardized and the IRB approaches in this setup.…”

Banking Competition, Housing Prices and Macroeconomic Stability

“…From (27) we see that entrepreneurial debt is more sensitive to changes in the nominal lending rate when expected capital gains from housing investments, in nominal terms, E t h t+1 t+1 , are high. This re ‡ects the fact that high expected capital gains tend to amplify the e¤ect of a change in R i;e t on the amount of pledgeable collateral in hands of entrepreneurs, and hence, the response of their demand for funding.…”

“…where we have used the fact that in a symmetric equilibrium the market share of each 20 bank is simply 1=n: Equation (33), when combined with (27), can also be expressed as…”

“…In this context, this model has been used including, among others, by Chiappori et al (1995), Freixas and Rochet (1997), Dell'Ariccia (2001) and Repullo (2004). 2 Of course, this utility cost is a pragmatic modelling device aimed at capturing the sources of monopolistic power by banks over and above those strictly related to literal transportation cost.…”