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Capital requirements in a quantitative model of banking industry dynamics

Author

Listed:
  • Dean Corbae
  • Pablo D'Erasmo
Abstract
We develop a model of banking industry dynamics to study the quantitative impact of capital requirements on bank risk taking, commercial bank failure, and market structure. We propose a market structure where big, dominant banks interact with small, competitive fringe banks. Banks accumulate securities like Treasury bills and undertake short-term borrowing when there are cash flow shortfalls. A nontrivial size distribution of banks arises out of endogenous entry and exit, as well as banks? buffer stocks of securities. We test the model using business cycle properties and the bank lending channel across banks of different sizes studied by Kashyap and Stein (2000). We find that a rise in capital requirements from 4% to 6% leads to a substantial reduction in exit rates of small banks and a more concentrated industry. Aggregate loan supply falls and interest rates rise by 50 basis points. The lower exit rate causes the tax/output rate necessary to fund deposit insurance to drop in half. Higher interest rates, however, induce higher loan delinquencies as well as a lower level of intermediated output.

Suggested Citation

  • Dean Corbae & Pablo D'Erasmo, 2014. "Capital requirements in a quantitative model of banking industry dynamics," Working Papers 14-13, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:14-13
    Note: SUPERSEDED BY WP 21-24
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    References listed on IDEAS

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    More about this item

    Keywords

    Banking; Capital requirements; Risk; Commercial bank failure; Market structure;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms

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