Aggregate Bank Capital and Credit Dynamics
53 Pages Posted: 30 Jun 2016
Date Written: June 1, 2016
We develop a novel dynamic model of banking showing that aggregate bank capital is an important determinant of bank lending. In our model commercial banks finance their loans with deposits and equity, while facing equity issuance costs. Because of this financial friction, banks build equity buffers to absorb negative shocks. Aggregate bank capital determines the dynamics of lending. Notably, the equilibrium loan rate is a decreasing function of aggregate capitalization. The competitive equilibrium is constrained inefficient, because banks do not internalize the consequences of individual lending decisions for the future loss-absorbing capacity of the banking sector. In particular, we find that unregulated banks lend too much. Imposing a minimum capital ratio helps tame excessive lending, which enhances stability of the banking system.
Keywords: macro-model with a banking sector, aggregate bank capital, pecuniary externality, capital requirements
JEL Classification: E21, E32, F44, G21, G28
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