Bank Capital Regulation with Unregulated Competitors

We analyze optimal capital regulation of imperfectly competitive banks that are confronted with competition from non-regulated banks. We characterize banks as having access to deposit insurance and underly banking regulation in exchange. Non-regulated banks also perform lending activities but cannot fund themselves with insured deposits. We show that tightening bank regulation reduces the social cost of bank defaults but can also result in lower bank lending. A competitive non regulated banking sector can reduce the negative impact of less bank lending and, thereby, can allow for stricter bank regulation. We show how in regulated banking sectors with high market power, an increase in competition from non-regulated banks results in tighter optimal bank regulation and higher welfare. However, in regulated banking sectors with lower market power, an increase in competition from non-regulated banks may lead to looser capital regulation and lower welfare.