Abstract

This paper studies moral hazard in banking due to delegated monitoring in an environment of aggregate risk and examines its implications for credit market equilibrium and regulation, in a model where banks are price competitors for loans and deposits. It provides a rationale for an incentive-based lending capacity positively linked to the bank’s capital and profit margin, for an oligopolistic market structure wherever banks have market power, and for capital requirements. Social-welfare-maximizing capital requirements are lowered in recessions, are higher the more fragmented the banking sector, and are increased when anti-competitive measures are removed. In equilibrium banks earn excessive profits and credit may be rationed.