Research Discussion Papers, Bank of Finland
Should new or rapidly growing banks have more equity?
Abstract: There is substantial evidence that new banks and rapidly
growing banks are risk prone. We study this problem by designing a
relationship-lending model in which a bank operates as a financial
intermediary and centralised monitor. In the absence of deposit insurance,
the bank’s limited liability option creates an incentive problem between
the bank and its depositors, the likely outcome of which is a reduction in
the amounts of resources allocated to monitoring its borrowers. Hence, the
bank must signal its safety to depositors by maintaining the equity ratio
held. The optimal equity ratio is dynamic, ie new banks need relatively
more equity than established banks, which enjoy profitable old lending
relationships – charter value – that reduce the incentive problem. However,
if an established bank grows rapidly, its share of old relationships also
decreases and the bank will have to raise its equity ratio. With deposit
insurance, regulators should set higher equity requirements for new banks
and rapidly growing banks than for those in a more established position.
The results of the model can be extended to more general inter-firm control
of credit institutions.
Keywords: financial intermediation; relationship banking; financial fragility; bank regulation; deposit insurance; moral hazard; product quality; (follow links to similar papers)
JEL-Codes: G11; G21; G28; (follow links to similar papers)
40 pages, September 4, 2001
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