An alternative view on regulatory distortions in a competitive financial services industry

We present an alternative view on regulatory distortions in the banking ind ustry. We use the duopoly model developed by Boot, Dezelan, and Milbourn (B DM, 2000), where a bank with low monitoring costs faces a bank with high mo nitoring costs. We show that when the initial level of the capital requirem ent is low, an increase of the minimum ratio between capital and total asse ts causes a higher decrease in profits at the bad bank than at the good ban k. This finding contrasts with BDM's theorem 1, which predicts that a regul ation imposing an identical increase in production costs on both banks will cause a greater loss in profits at the good bank than at the bad bank. We also look at the impact of an increase in the minimum ratio between capital and total assets on the profits of a representative bank in three other co mpetitive environments identified in BDM. We find that the decrease in the representative bank's profit caused by an increase in the capital requireme nt is larger when the bank faces competition from an unregulated firm than when it faces a regulated competitor or no competitor at all. This result i s consistent with BDM's theorem 2.