Capital Buffers in a Quantitative Model of Banking Industry Dynamics

Abstract

We develop a model of banking industry dynamics to study the quantitative impact of regulatory policies on bank risk‐taking and market structure. 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 as well as non‐bank lenders. 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 capital. We show that 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 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.