Bank Portfolio Choice, Uninsurable Risks and Regulatory Constraints

We use individual U.S. commercial bank balance sheet and income statement information
to develop stylized facts about bank portfolio choices in both the cross section and over
time. We then estimate the structural parameters of a quantitative model of bank portfolio
choices (new loans, liquid investments and endogenous failure) that are made in the presence
of undiversi?able background risk (problem loans, interest rate spreads and deposit shocks)
and regulatory constraints. The loan portfolio is highly procyclical and banks curtail new
lending very aggressively in response to background risk shocks, such as a higher uncertainty
in bad loans or deposits. Bank failures are strongly countercyclical and depend positively on
leverage. Increasing equity requirements generates higher equity but also results in higher
failures because the increase in equity is less than proportional to the increase in the leverage
limit, whereas background risk remains the same.