Bank capital regulation in the presence of unregulated competitors

We analyze optimal bank regulation in a setup where regulated banks are confronted with competition from unregulated institutions. The appearance of unregulated competitors alleviates the (possible) contraction in loan access resulting from stricter regulation as borrowers gain access to alternative funding sources. This effect increases optimal regulation and the welfare of the economy. In contrast, with moderate market power of banks, increased efficiency in the unregulated sector can harm welfare and result in lower optimal regulation because market power may cause inefficient lending allocation under strict regulation.