Abstract
How long does it take for the stock of financial intermediation capital to return to its optimal, profit maximizing, level following a severe shock, and what is the mechanism that governs it? We introduce a dynamic neoclassical model of capital structure that is governed by the process of capital accumulation and which adheres to stylized features of banking (non-competitive market, adverse selection, moral hazard, monitoring, and market discipline). The model is applied to U.S banks data where we (i) assess the validity of our model by simulating it and comparing the derived dynamics against the actual, and (ii) examine the empirical reaction of our model to (a) risk shock, (b) business cycle shock and (c) monetary policy shock. We examine each shock separately and derive the reaction of the capital ratios of large and small banks. Our model generates important information regarding the speed of convergence of capital to its optimal level following a severe shock, as well as the mechanism that governs it and implications for banking supervision policies.
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