09.07.2019; Kolloquium
Colloquium: "Heterogenous Banks, Portfolio Choice, and Capital Requirements"
Abstract:
The paper proposes a rich yet tractable equilibrium model of bank behavior. Banks differ in their abilities which affect their productivities, and their bankruptcy risks. Each bank takes decisions regarding its portfolio choice (high risk or low risk), its equity ratio, and its size. Higher-ability (lower-ability) banks sort themselves into high-risk (low risk) projects; bank size and profits increase in ability. We establish that for uniform (exogenous) equity holdings, regulatory capital requirements have an ambiguous effect on the likelihood of bank default: while higher equity serves as a buffer to avoid insolvency, regulation may induce a switch in bank strategy towards a high risk portfolio.
Endogenizing the choice of equity holdings, we show that high risk portfolios may be associated with smaller equity ratios. Moreover, moderate capital requirements may be optimal because they become binding only for those banks which hold risky assets.