Abstract

We assess the influence of competition and capital regulation on the stability of the banking system, and particularly on the monitoring incentives of banks. We show that competition improves the monitoring incentives of better quality banks and deteriorates the incentives of lower quality banks. Our key result is that precisely for those lower quality banks competition also compromises the effectiveness of capital requirements. Our approach deviates from the extant literature in that it recognizes the fixed costs associated with banks’ monitoring technologies. We generalize the analysis along a few dimensions. One is where we allow endogenous bank entry, and ask the question how capital regulation affects entry into the industry. In another extension we analyze the effects of asymmetric competition, i.e. one country that opens up its banking system but not vice versa.