Bank Capital, Bank Concentration, and Risk Taking

How does bank capital affect the relationship between bank concentration and risk taking? I develop a tractable dynamic model with heterogeneous financially constrained entrepreneurs and an imperfectly competitive banking sector. Based on the model, when the bank capital ratio exceeds the minimum requirement, intensifying bank competition leads to more risk taking; otherwise, no significant correlation is observed. To explain the equilibrium characterization, I propose two mechanisms, a risk shifting mechanism and a net margin mechanism, the direction of which will be determined by the banks’ optimal decisions on the loan rate and the accumulation of excess bank capital. The two forces also jointly determine a non-monotonic relationship between bank concentration and efficiency. I discuss how efficiency and stability can be enhanced simultaneously.

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Bank Concentration, Bank Capital, and Misallocation, 2022
U.S. bank concentration, together with the bank capital, have been rising over the last thirty years. Based on the stylized facts, I develop a tractable dynamic model with heterogeneous financially constrained entrepreneurs and an imperfectly competitive banking sector. The model implies that increasing bank concentration leads to an increase in bank capital and a possibly non-binding capital constraint. I use the model to understand how bank concentration affects misallocation through the interaction between bank concentration and bank capital when the financial market is incomplete, which I refer to as the “bank capital channel”. This channel suggests that banks over-accumulate equity capital in terms of allocative efficiency, based on which I discuss implications on regulations.

Placement Officer
Mark Schankerman

Supervisors/Advisors
Shengxing Zhang

References
Shengxing Zhang
Ricardo Reis
Ben Moll 
Wouter Den Haan

Email
Y.YI3@lse.ac.uk

Office Address
Department of Economics
London School of Economics and Political Science
Houghton Street, London WC2A 2AE