Market Freeze and Bank Capital Structure Heterogeneity

Abstract

This paper develops a theory in which heterogeneity in bank capital choices arises in a general equilibrium despite ex ante identical banks. In a future state, the credit market is partially frozen in a crisis - high-capital banks have continued access to funding liquidity but low-capital banks do not. Inter-bank trading in legacy assets allows some frozen banks to sell assets to banks with “financial muscle” to obtain funding. Consequently, there is a reallocation of access to market funding from low-capital to high-capital banks. Inter-bank trading unfreezes the market without government intervention.