Corporate Governance

Credit Market Competition and Capital Regulation

By Harvard Law School Program on Corporate Governance

In our paper, Credit Market Competition and Capital Regulation, which was recently accepted for publication in the Review of Financial Studies, we present a theory that demonstrates that inducements for banks to hold capital can also come from the asset side. We show that when credit markets are competitive, market discipline coming from the asset side induces banks to hold positive levels of capital as a way to commit to monitor and attract borrowers.

We develop a simple one-period model of bank lending, where firms need external financing to make productive investments. Banks grant loans to firms and monitor them, which helps improve firms? expected payoff. Given that monitoring is costly and banks have limited liability, banks are subject to a moral hazard problem in the choice of monitoring effort. One way of providing them with greater incentives for monitoring is through the use of equity capital. This forces banks to internalize the costs of their default, thus ameliorating the limited liability problem banks face due to their extensive reliance on deposit-based financing. A second instrument to improve banks? incentives is embodied in the loan rate. A marginal increase in the loan rate gives banks a greater incentive to monitor in order to receive the higher payoff if the project succeeds and the loan is repaid. Thus, capital and loan rates are alternative ways to improve banks? monitoring incentives, but entail different costs. Holding capital implies a direct private cost for the banks, whereas increasing the loan rate has a negative impact only for borrowers in terms of a lower return from the investment. We consider both the case where there is and isn?t deposit insurance.

Our basic finding is that 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. Through a series of adjustments to our model, we develop a number of empirical implications. First, our results are consistent with the fact that banks voluntarily hold higher levels of capital than the regulatory minimum and that changes in capital regulation do not affect banks? capital structures. Second, the model suggests that greater credit market competition increases capital holdings as it introduces market discipline from the asset side. Third, the model suggests that banks that are more involved in monitoring-intensive lending should be more capitalized and that, similarly, firms for which monitoring adds the most value should prefer to borrow from banks with high capital. Fourth, our analysis implies that banks? capital holdings decrease with fixed-deposit insurance coverage. Fifth, our analysis suggests that increased capital requirements imply a shift in banks? portfolios away from transactional lending toward more relationship lending. Finally, the model predicts that banks with a lower fraction of outside equity or in countries with stronger shareholder rights should be more capitalized than banks with more dispersed ownership.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on December 11, 2009 (boomark / email).