Competition and risk taking in the banking industry: The case of capital requirements

This article examines how stricter capital requirements affect competition and risk-taking incentives in the banking industry. When banks choose their risk profiles by solving portfolio problems, there is a clear trade-off between competition and risk taking: stricter capital requirements restrict risk taking but soften competition for deposits. The clear trade-off disappears when banks compete in a loan market rather than choose their risk profiles directly. In this case, stricter capital requirements will lead to less risk taking only if they also lead to stronger competition in the loan market.