Capital Requirements in a Quantitative Model of Banking Industry Dynamics

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 banks with market power interact with small, competitive fringe banks. Banks face idiosyncratic funding shocks as well as aggregate shocks to the fraction of performing loans in their portfolio. A nontrivial size distribution of banks arises out of endogenous entry and exit, as well as banks’ bu.er stock of net worth. We test the model using business cycle properties and the bank lending channel across banks of di.erent sizes. We then conduct a series of counterfactuals (including countercyclical requirements and size contingent (e.g. SIFI) requirements). We .nd that regulatory policies can have an important impact on market structure itself.