Capital requirements and competition in the banking industry

Abstract

This paper focuses on the interaction between regulation and competition in an industrial organisation model. We analyse how capital requirements affect the profitability of two banks that compete as Cournet duopolists on a market for loans. Bank management of both banks choose optimal levels of loans provided, equity ratio and effort to reduce loan losses so as to maximise profits. From the regulator's point of view, the free market solution is not optimal as private banks do not take into account the consumer surplus and the social cost of bankruptcy (financial stability aspects). It is shown that capital requirements may improve welfare, even under conditions that both banks would never default. Moreover, we find that higher capital requirements impose a higher burden on the inefficient bank than on the efficient one, even though the requirement may only be binding for the efficient bank. If the inefficient bank chooses a strategy that might result in bankrutpcy, capital requirements are particularly welfare improving.Cournot duopoly; Capital requirements; Profit paradox; level playing field