Market Competition and Bank Capital

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During the last financial crisis, bank capital has been proven to be crucial for banks’ resilience, their performance and, most importantly, their loan supply during distress times. As a response to the crisis, policy makers have increased the minimum required capital ratios for all banks, and the increase was even larger for systemically important banks. Given the importance of bank capital and its positive impact on financial stability, it is essential to understand the determinants of banks’ capital ratios and the possible unintentional indirect effects of other regulation or policy responses on banks’ capital ratios. In this project, we aim to contribute to this discussion by studying the following questions: 1) What is the impact of an increase in credit market competition on banks’ capital ratios? 2) Does an increase in bank capital change banks’ loan portfolios? Do banks decrease their arm’s length loans and increase their relationship loans when they experience an increase in their capital?3) Does holding higher capital ratios give banks competitive advantage in their local deposit markets?In the first part of our project, our aim is to understand whether banks adjust their capital ratios when the credit market competition changes in the markets where these banks are active. This enables us to assess possible indirect effects of recent changes in credit market competition on banks’ capital. The second part of our project deals with the impact of banks’ being enforced to increase their capital after stress tests on their allocation of loans between transactional lending and relationship lending. Stress tests became part of monetary policy since the last financial crisis. In this part of our project, we aim to understand the possible effects of stress tests on the distribution of loans across borrowers. Finally, in the last part of our project, we study the incentives for banks to hold higher capital ratios. Recent empirical studies show that banks hold capital ratios well above the minimum required capital levels. The last part of our project contributes to this discussion by analyzing whether higher capital ratios give banks competitive advantage in their deposit markets. Overall, our aim is to shed light on the determinants of banks’ capital ratios to support the resilience of the banking system and to strengthen the financial stability.