A Q-Theory of Banks

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.