Market Freeze and Bank Capital Structure Heterogeneity

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 do no 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. This endogenously arising 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. This paper was accepted by Bruno Biais, finance.