Market Freeze and Bank Capital Structure Heterogeneity

Management Science

42 Pages Posted: 17 Sep 2020 Last revised: 22 Feb 2022

See all articles by Fenghua Song

Fenghua Song

Pennsylvania State University - Smeal College of Business

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Date Written: February 19, 2022

Abstract

We develop a theory wherein a priori identical banks may trade loans in a search market with reusable information. The equilibrium is unique but its nature depends on the probability of a future market state. When the probability of a boom is high, all banks hold no equity and avoid screening. When this probability is low, all banks choose a high level of equity and screen loans. For intermediate probability values, the equilibrium is heterogeneous with some banks posting equity and screening, and others avoiding equity and screening. Heterogeneity generates interbank trading. The credit market is partially frozen in a recession: only high-capital banks have continued funding access. Low-capital banks obtain funding by selling legacy loans to banks with "financial muscle," so market funding is reallocated from low-capital to high-capital banks.

Keywords: Market freeze, Bank capital, Information reusability, Short-term funding reallocation

JEL Classification: G01, G20, G21

Suggested Citation

Song, Fenghua and Thakor, Anjan V., Market Freeze and Bank Capital Structure Heterogeneity (February 19, 2022). Management Science , Available at SSRN: https://ssrn.com/abstract=3667175 or http://dx.doi.org/10.2139/ssrn.3667175

Fenghua Song (Contact Author)

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)

HOME PAGE: http://sites.google.com/site/fenghua8song/

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Financial Theory Group ( email )

United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

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