Working Paper: NBER ID: w25424
Authors: Dean Corbae; Pablo Derasmo
Abstract: We develop a model of banking industry dynamics to study the quantitative impact of capital requirements on equilibrium bank risk taking, commercial bank failure, interest rates on loans, and market structure. We propose a market structure where big banks with market power interact with small, competitive fringe banks. Banks face idiosyncratic funding shocks in addition to aggregate shocks to the fraction of performing loans in their portfolio. A nontrivial bank size distribution arises out of endogenous entry and exit, as well as banks' buffer stock of net worth. We show the model predictions are consistent with untargeted business cycle properties, the bank lending channel, and empirical studies of the role of concentration on financial stability. We then conduct a series of counterfactuals (including countercyclical and size contingent (e.g. SIFI) capital requirements). We find that regulatory policies can have an important impact on market structure in the banking industry which, along with selection effects, can generate changes in allocative efficiency.
Keywords: capital requirements; banking; market structure; risk-taking; financial stability
JEL Codes: E44; G21; L11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in capital requirements from 4% to 8.5% (O16) | Increase in long-run exit rates of small banks (E44) |
| Increase in capital requirements from 4% to 8.5% (O16) | Greater likelihood of failure among smaller institutions (I23) |
| Increase in capital requirements from 4% to 8.5% (O16) | More concentrated industry (L69) |
| Increase in capital requirements from 4% to 8.5% (O16) | Short-run loss of market share for fringe banks (G21) |
| Increase in capital requirements from 4% to 8.5% (O16) | Long-run loss of market share for fringe banks (G21) |
| Increase in capital requirements from 4% to 8.5% (O16) | Decrease in aggregate lending (G21) |
| Decrease in aggregate lending (G21) | Increase in interest rates on loans (E43) |
| Decrease in aggregate lending (G21) | Modest increase in interest rates on loans (E43) |
| Imposition of liquidity requirements alongside capital requirements (G28) | Significant reduction in probability of a banking crisis (F65) |
| Increase in capital requirements from 4% to 8.5% (O16) | Changes in bank failures, interest rates, and market shares (G21) |