Capital Buffers in a Quantitative Model of Banking Industry Dynamics

74 Pages Posted: 14 Jun 2021 Last revised: 18 Jun 2022

See all articles by Dean Corbae

Dean Corbae

University of Wisconsin - Madison

Pablo D'Erasmo

Federal Reserve Bank of Philadelphia - Research Department

Date Written: June, 2021

Abstract

We develop a model of banking industry dynamics to study the quantitative impact of regulatory policies on bank risk taking and market structure as well as the feedback effect of market structure on the efficacy of policy. Since our model is matched to U.S. data, we propose a market structure where big banks with market power interact with small, competitive fringe banks. Banks face idiosyncratic funding shocks in addition to aggregate shocks which affect the fraction of performing loans in their portfolio. A nontrivial bank size distribution arises out of endogenous entry and exit, as well as banks’ buffer stock of net worth. We show the model predictions are consistent with untargeted business cycle properties, the bank lending channel, and empirical studies of the role of concentration on financial stability. We then conduct a series of policy counterfactuals motivated by those proposed in the Dodd-Frank Act (size and state dependent capital requirements and liquidity requirements). We find that regulatory policies can have an important impact on banking market structure, which, along with selection effects, can generate changes in allocative efficiency and stability.

Keywords: macroprudential policy, bank size distributions, industry dynamics with imperfect competition.

JEL Classification: E44, G21, L11

Suggested Citation

Corbae, Dean and D'Erasmo, Pablo, Capital Buffers in a Quantitative Model of Banking Industry Dynamics (June, 2021). FRB of Philadelphia Working Paper No. 21-24, Available at SSRN: https://ssrn.com/abstract=3865895 or http://dx.doi.org/10.21799/frbp.wp.2021.24

Dean Corbae (Contact Author)

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

Pablo D'Erasmo

Federal Reserve Bank of Philadelphia - Research Department ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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