Working Paper: NBER ID: w27935
Authors: Juliane Begenau; Saki Bigio; Jeremy Majerovitz; Matias Vieyra
Abstract: We introduce a dynamic bank theory featuring delayed loss recognition and a regulatory capital constraint, aiming to match the bank leverage dynamics captured by Tobin’s Q. We start from four facts: (1) book and market equity values diverge, especially during crises; (2) Tobin’s Q predicts future bank profitability; (3) neither book nor market leverage constraints are strictly binding for most banks; and (4) bank leverage and Tobin’s Q are mean reverting but highly persistent. We demonstrate that delayed loss accounting rules interact with bank capital requirements, introducing a tradeoff between loan growth and financial fragility. Our welfare analysis implies that accounting rules and capital regulation should optimally be set jointly. This paper emphasizes the need to reconcile regulatory dependence on book values with the market’s emphasis on fundamental values to enhance understanding of banking dynamics and improve regulatory design.
Keywords: Banking; Leverage Dynamics; Tobin's Q; Delayed Loss Recognition; Regulatory Capital Constraints
JEL Codes: G21; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Delayed loan loss recognition (G33) | Divergence between book equity and market equity (G19) |
| Divergence between book equity and market equity (G19) | Market equity is a better predictor of future bank profitability (G17) |
| Tobin's q (G19) | Predicts future bank profits and loan charge-offs (G21) |
| Cross-sectional dispersion of market leverage increases during financial crises (F65) | Book leverage remains stable (G32) |
| Banks adjust slowly to net worth shocks (G21) | Market leverage shows a delayed response compared to book leverage (G19) |