Supersedes Working Paper 14-13 – Capital Requirements in a Quantitative Model of Banking Industry Dynamics

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.