Market Freeze and Bank Capital Structure Heterogeneity
Management Science
42 Pages Posted: 17 Sep 2020 Last revised: 22 Feb 2022
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: Suggested Citation