Bank Regulation and Market Structure

Abstract

Following the recent and on-going tightenings of capital requirements in response to the financial crisis many experts have predicted a decline in the importance of the banking sector as banks struggle to compete with other providers of financial intermediation. The purpose of our research is to investigate this hypothesis in a model where the need for bank regulation is explained from first principles.Our analysis suggests that, in a monopolistic competition setting, with higher capital requirements the bank sector may see bank competition reduced as the sector becomes dominated by fewer banks. Parallel with this development depositors may stop using banks in favor of an outside option that can be interpreted as banks which are either unregulated or subject to other, possibly less stringent, types of regulation. It is noteworthy that the first effect goes against an objective often stated by regulators, namely to reduce the number of large banks in the market, banks which may be "too big to fail".We explain tightened capital requirements as the regulator's response to financial innovation. In our model such innovation increases the riskiness of certain asset classes without improving on their expected return. The only way to prevent banks from using these new assets is by increasing the capital requirements for all asset classes. The costs of these requirements are ultimately born by depositors and may lead them to look for better returns elsewhere.Our model builds on the Salop (1979) model and in doing so also sheds some light on its properties. In particular we show that so-called monopoly equilibria only exist when the number of banks is constrained to be an integer.