Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions

This paper develops a structural, dynamic model of a banking firm to analyze how banks adjust their loan portfolios over time. In the model, banks experience capital shocks, face uncertain future loan demand, and incur costs based on their proximity to regulatory minimum capital requirements and the intensity of regulatory monitoring. Implications of the model then are estimated using panel data on large US commercial banks operating continuously between December 1989 and December 1997. The estimated model is used to simulate the optimal bank response to: 1. past and proposed changes in capital requirements, 2. changes in regulatory monitoring intensity, and 3. economic downturns.