Capital Regulation and Loan Monitoring in a Diverse Banking System

Building on the literature emphasizing banks’ monitoring functions, recent contributions to the literature examining the effects of capital regulation have focused attention on the influences of capital requirements on bank incentives to monitor loans for moral hazard risks. Empirical evidence suggests that this is a potentially important issue to contemplate when judging the usefulness of capital regulation as a means of reducing banking risks. This evidence also suggests, however, that various heterogeneities, which are commonly ignored in studies of the effects of capital regulation on bank monitoring and overall asset risk, are an important feature of real-world banking markets. In theory, bank heterogeneities can affect the manner in which the entire banking system responds to external shocks, such as the imposition of capital requirements. A few recent studies cast light on how diversity relating to loan-monitoring activities of banks affects their decision making and thereby influences market outcomes, which in turn feed back to alter individual bank choices regarding whether or how much to monitor their loans. In this way, the policy implications of capital regulation differ from those forthcoming from standard studies of banking systems populated by identical, representative banks.