A Dynamic Model of Endogenous Bank Capital Buffer

Abstract

We develop a dynamic model of endogenous bank capital choice in which banks cannot access the equity market to raise capital in some states due to equity market frictions. In these frictional states, banks with a shortage in bank capital need to choose between shrinking their relationship lending and eating up their capital buffer to meet the capital requirements. Our model suggests that a typical bank will try to keep valuable relationship lending and prefer to eat up capital buffers first. Intertemporally, this effect also leads to banks keeping capital buffers above the regulatory capital requirement. Thus in the aggregate, our model quantitatively shows that capital requirements alleviate credit rationing in bad states of the economy by inducing a higher endogenous bank capital buffer which effectively insures the banks from bankruptcy, and hence reducing bankruptcy rate and the associated credit supply loss.