Capital Requirements in a Quantitative Model of Banking Industry Dynamics

58 Pages Posted: 30 Apr 2014

See all articles by Dean Corbae

Dean Corbae

University of Wisconsin - Madison

Pablo D'Erasmo

University of Maryland - College Park; Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Multiple version iconThere are 2 versions of this paper

Date Written: April 4, 2014

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.

Keywords: Banking, Capital requirements, Risk, Commercial bank failure, Market structure

Suggested Citation

Corbae, Dean and D'Erasmo, Pablo N., Capital Requirements in a Quantitative Model of Banking Industry Dynamics (April 4, 2014). FRB of Philadelphia Working Paper No. 14-13. Available at SSRN: https://ssrn.com/abstract=2430778 or http://dx.doi.org/10.2139/ssrn.2430778

Dean Corbae (Contact Author)

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

Pablo N. D'Erasmo

University of Maryland - College Park ( email )

College Park, MD 20742
United States

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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