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Banking Competition, Risk and Regulation

Wilko Bolt () and Alexander Tieman

Scandinavian Journal of Economics, 2004, vol. 106, issue 4, 783-804

Abstract: In a dynamic framework, commercial banks compete for customers by setting acceptance criteria for granting loans, while taking into account regulatory requirements. By easing its acceptance criteria a bank faces a trade-off between attracting more demand for loans, thus making higher per-period profits, and deterioration in the quality of its loan portfolio, thus tolerating a higher risk of failure. Our main results state that more stringent capital adequacy requirements lead banks to set stricter acceptance criteria, and that increased competition in the banking industry leads to riskier bank behaviour. It is shown that risk-adjusted regulation is effective. In an extension of our basic model, we show that it may be beneficial for a bank to hold more equity than prescribed by the regulator, even though issuing equity is more expensive than attracting deposits. Copyright The editors of the "Scandinavian Journal of Economics", 2004 .

Date: 2004
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