The bank capital channel and bank profits

• Author: Paul E. Orzechowski
• Date: 01 July 2019
• Published date: 01 July 2019
• DOI: http://doi.org/10.1002/rfe.1054

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2019;37:372–388.

© 2019 University of New Orleans

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INTRODUCTION

The aim of this study is to highlight an endogenous loan creation process resulting from bank profits and bank capital.

Specifically, this article is focused on a bank's profit rate and capital accumulation process via the bank's retained earnings that

could be an important endogenous element, ceteris paribus, in determining future lending activities. Bank profits in this model

are primarily the result of the traditional banking transformation of turning short- term deposits into long- term loans by focusing

on the interest rate difference between the deposit rate and the lending rate. The following analysis illustrates how a bank's net

interest margins (NIM(s)) may influence the bank's profit rate, the bank's ability to grow future loans via the bank's profit rate,

and the bank's portfolio decisions.

The model develops a simple theoretical microeconomic model of banking that extends the bank capital channel (BKC)

literature and the broader literature that studies the effects of bank capital on the economy by demonstrating the maximum

amount of lending allowed by regulatory capital requirements as the main constraint on lending in a dynamic setting. Thus,

the banking model presented in this study introduces a bank capital- loan multiplier to help show the theoretical loan maximum

given a certain amount of bank capital. These illustrations are in the spirit of the textbook deposit multiplier, which offers a

simple demonstration of the maximum bound on money creation based on deposit reserves.

The study fills in the gaps of the related BKC literature and the broader bank capital literature by modeling endogenous

money based on a bank's NIMs along with introducing risk parameters based on risk- weighted assets, portfolio choices, and

transaction costs within a dynamic interest rate environment. The emphasis on bank- level detail is in the spirit of the micro-

economic analysis of banking advocated by Freixas and Rochet (1997) in their book Microeconomics of Banking. In contrast,

many bank capital- related models use banking as a part of a general equilibrium model, such as those offered by Chen (2001),

Aliaga- Diaz and Olivero (2012), and Meh and Moran (2010).

Received: 12 December 2017

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Revised: 18 November 2018

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Accepted: 20 November 2018

DOI: 10.1002/rfe.1054

ORIGINAL ARTICLE

The bank capital channel and bank profits

Paul E.Orzechowski

This paper was part of my dissertation work at the New School for Social Research.

Department of Finance,College of Staten

Island—CUNY, Staten Island, New York

Correspondence

Paul E. Orzechowski, Department of

Finance, College of Staten Island—CUNY,

Staten Island, NY.

Email: paul.orzechowski@csi.cuny.edu

Abstract

This paper develops a microeconomic model of banking to highlight an endogenous

loan creation process that emerges from bank profits via the capital accumulation of

retained earnings and uses a simple bank capital- loan multiplier to illustrate con-

straints on lending. The study also analyzes how sufficient net interest margins are

important for banks to maintain lending portfolios and avoid financial fragility. The

model offers support to bank capital channel (BKC) economists by illustrating how

changes in interest rates may influence bank lending through the bank's internal capi-

tal accumulation growth rate and on a bank's portfolio choices.

JEL CLASSIFICATION

E43, E51, E52, G21

KEYWORDS

bank capital, bank capital channel, bank profit, endogenous money, monetary policy

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ORZECHOWSKI

Aikman and Vlieghe (2004), Gambacorta and Mistrulli (2004), and Van den Heuvel (2002) lead the BKC school of thought

that seeks to establish a separate monetary transmission channel to analyze the effects of monetary policy on lending and invest-

ment. The BKC school focuses on how bank capital may amplify the impact of monetary policy on lending. This study hopes

to answer the traditional question within the BKC literature: How does bank capital matter in loan determination? However,

this study also hopes to answer the following questions: How can the BKC explain endogenous loan supply? How can a BKC

model demonstrate the maximum bounds on lending using risk- based capital constraints? How can changes in a bank's NIMs

influence a bank's portfolio choices?

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BACKGROUND AND LITERATURE REVIEW

Mishkin (1995) provides a detailed overview of the possible monetary transmission channels and suggests three broad ones:

the traditional interest rate channel, the other asset pricing effects channel, and the credit view channel. Kuttner and Mosser

(2002) offer similar channel outlines.

One of the main banking channels within the broad credit view is known as the bank lending channel (BLC), which was

developed by Bernanke and Blinder (1988). The BLC works from the assumption that monetary policy can shift the banks’

loan supply (by way of deposits via the deposit- reserve multiplier) and thus influence bank- dependent loans/borrowers. Several

empirical studies support the assumption of a significant bank- dependent borrowing class. Oliner and Rudebusch (1992);

Gertler and Gilchrist (1994); and Bernanke, Gertler, and Gilchrist (1996) show that small- to medium- sized manufacturers are

especially dependent on bank loans. Berger and Udell (1998) indicate that newer small businesses are dependent on bank loans.

However, some economists advocate a separate BKC in the analysis of the monetary transmission mechanism and banking.

Aikman and Vlieghe (2004), Gambacorta and Mistrulli (2004), and Van den Heuvel (2007) outline how bank capital amplifies

monetary policy and plays a distinct role in the determination of loan supply and real economic activity. The BKC emphasizes

bank capital, as opposed to the traditional BLC, which emphasizes deposit- reserve requirements regarding the loan supply

in the banking system. The BKC school argues that the bank's financial structure is important to macroeconomic activity, as

opposed to the Modigliani–Miller theorem, which treats capital and debt in the same way. Financial structure refers to the way

in which a bank establishes their liabilities and capital in order to support the asset side of the bank's balance sheet. Liabilities

usually involve contractual legal obligations on the part of the bank that require payments subject to the agreed upon terms. In

contrast, equity capital is a usually a permeant paid- in source of funding that is subordinate to liability claims and cannot be

withdrawn easily from the banking structure.

Nevertheless, the study of bank capital and its impact on the economy and lending is not new. Bernanke and Gertler (1987),

Bernanke and Lown (1991), Blum and Hellwig (1995), Peek and Rosengren (1995), Thakor (1996), Kiyotaki and Moore

(1997), Holmstrom and Tirole (1997), Furfine (2001), and Chen (2001) conducted previous studies on the role of bank capital

within banking and the economy. Interest in bank capital began following the 1990–1991 recession and the implementation of

the Basel Accords in the United States among economists and bankers who questioned the role of bank capital as it related to

real estate values and lending. For example, Bernanke and Lown (1991) show evidence that a reduction in lending during the

1990–1991 recession was linked to a reduction in bank capital.

A larger amount of net worth and/or collateral usually increases confidence, decreases risk, and reduces moral hazard and

adverse selection problems. Some New Keynesian economists have established a framework (based on informational eco-

nomics) that relies on net worth (bank capital) and cash flow (bank profits) as important variables in determining a bank's

asymmetric problems as more bank capital can mitigate these problems. For example, Diamond and Rajan (2002) indicate that

there is an optimal level of bank capital that is important to the bank's ability to obtain a favorable cost of funds. Enough capital

is needed at the bank to maintain confidence and mitigate any market concerns about asymmetric information. Berger (1991)

shows that bank stockholders, depositors, and note holders may withdraw their funds if they view bank capital as too low.

Kishan and Opiela (2006) show that financial structure and size play an important role in the effectiveness of monetary policy

in influencing loan activity. Carlson, Shan, and Warusawitharana (2013) show that there is a significant positive relationship

between a bank's capital ratios and a bank's loan growth during and after the 2008–2009 financial crisis. Empirical evidence

by Gambacorta and Shin (2018) show that a 1.0% increase in a bank's equity to total asset ratio is related to a four basis- point

decrease in the bank's cost of debt and a 0.6% increase in loan growth. Hugonnier and Morellec (2017) developed a dynamic

model of banking that featured bank capital and liquidity as well as other parameters such as taxes and default costs. They con-

clude that the combination of high liquidity and lower leverage reduce the likelihood of bank default.

Bernanke and Gertler (1987), Carlstrom and Fuerst (1997), Chen (2001), Holmstrom and Tirole (1997), Kiyotaki and Moore

(1997), Meh and Moran (2010), and Bolton and Freixas (2006) offer various types of macroeconomic equilibrium models that