DP10299 | A Dynamic Model of Banking with Uninsurable Risks and Regulatory Constraints

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We estimate the structural parameters of a quantitative banking model featuring maturity transformation and endogenous failures in the presence of undiversifiable background risk and regulatory constraints. Pervasive balance sheet cross-sectional heterogeneity can be rationalized with idiosyncratic shocks and differential access to wholesale funding markets. Moreover, loans are highly procyclical, bank failures strongly countercyclical and increasing in leverage. Tightening capital requirements increases precautionary equity but results in higher failures because equity rises proportionately less than the capital ratio requirement change. The endogenous fall in the expected return on equity lowers the incentive to further increase precautionary equity.