Banking competition, risk, and regulation

In a dynamic framework banks compete for customers by setting lending conditions for the loans they supply, taking into account the capital adequacy requirements posed by the regulator. By easing its lending conditions a bank faces a tradeoff between attracting more demand for loans, thus making higher per-period profits, and a deterioration of the quality of its loan portfolio, thus a higher risk of failure. Our main results state that more stringent capital adequacy requirements lead commercial banks to set more stringent loan conditions to their customers, and we show that increased competition in the banking industry leads banks to behave more risky. In this model we also look at risk-adjusted capital requirements and show that risk-based regulation is effective. We extend the basic model to have banks choose both their lending conditions and the level of bank capital. In this extended model it turns out that it may be beneficial for a bank to hold more equity than prescribed by the regulator, even though equity is more expensive than attracting deposits. We show that the same conclusions with respect to the effectiveness of regulation hold as in the standard model.