Incentive-based lending capacity, competition, and regulation in banking

This paper studies moral hazard in banking due to delegated monitoring in a n environment of aggregate risk and examines its implications for credit ma rket equilibrium and regulation, in a model where banks are price competito rs for loans and deposits. It provides a rationale for an incentive-based l ending 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 a re lowered in recessions, are higher the more fragmented the banking sector , and are increased when anti-competitive measures are removed. In equilibr ium banks earn excessive profits and credit may be rationed. Journal of Eco nomic Literature Classification Numbers. D82, G28, L13. (C) 2001 Academic P ress.