European Finance Association
Milan, Italy | August 25-27, 2021
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FIT 02: Theories of Banking Dynamics
Dynamic Banking and the Value of Deposits
1Columbia Business School; 2Ohio State University; 3Shanghai University of Finance and Economics
We propose a dynamic theory of banking where the role of deposits is akin to that of productive capital in the classical Q-theory of investment for non-financial firms. As a key source of leverage, deposits create value for well-capitalized banks. However, unlike productive capital of nonfinancial firms that typically has a positive marginal q, the deposit q can turn negative for undercapitalized banks. Demand deposit accounts commit banks to allow holders to withdraw or deposit funds at will, so banks cannot perfectly control leverage. Therefore, for banks with insufficient capital to buffer risk, deposit inflow destroys value through the uncertainty it brings in future leverage. This intertemporal channel complements the focus of static models on value destruction of deposit outflow and bank run. Our model predictions on bank valuation and dynamic asset-liability management are broadly consistent with the evidence. Moreover, our model lends itself to a re-evaluation of the costs and benefits of leverage regulation, offers alternative perspectives on banking in a low interest rate environment, and reveals new aspects of deposit market power that has unique implications on bank franchise value.
Dynamic Banking with Non-Maturing Deposits
1University of Pennsylvania and NBER; 2Peking University
Bank liabilities include debt with long-term maturities and deposits that typically are not withdrawn for extended periods. This subjects bank liabilities to debt dilution. Our analysis shows that this has major effects for how monetary policy shocks are transmitted to banks and for optimal capital regulation. Interest rate cuts produce protracted increases in bank risk which are stronger in low rate regimes. Capital regulation addresses debt dilution but are subject to a time-inconsistency problem. We compare Ramsey and Markov-perfect optimal policies and find that regulator commitment significantly impacts optimal bank capital regulation, sometimes in unexpected ways.
Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment
1Stanford Graduate School of Business; 2USC Marshall School of Business
We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. We confront the model with data on credit spreads, equity prices, credit, and output across the financial crisis cycle. In particular, we ask the model to match data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the post-crisis period characterized by a slow recovery in output. A pure amplification mechanism quantitatively matches the crisis and aftermath period but fails to match the pre-crisis evidence. Mixing sentiment and amplification allows the model to additionally match the pre-crisis evidence. We consider two versions of sentiment, a Bayesian belief updating process and one that overweighs recent observations. Both models match the crisis patterns qualitatively, while the non-Bayesian model better matches the pre-crisis froth quantitatively. Finally, we show that a lean-against-the-wind policy has a quantitatively similar impact in both versions of the belief model, indicating that policy need not condition on true beliefs.
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