Bank capital and credit market competition: Will competitive pressure lead to higher capital levels?

This paper establishes a theoretical model to study the relationship between credit market competition and bank capital. In the model, bank capital can alleviate the debt overhang problem, and the extent to which banks can enjoy the gain of holding capital is decreasing in the competitive pressure in the credit market. It is shown that credit market competition reduces banks' incentive to hold capital. Deposit insurance also induces banks to hold less capital. In addition, bank capital regulation is welfare improving, and banks may voluntarily hold capital in excess of regulatory minimums.