Bank’s regulation, asset portfolio choice of banks, and macroeconomic dynamics

Abstract

Since the middle of 1990s, the Japanese banks have continuously tilted their asset portfolio towards the government bonds, reducing their lending to firms. In this paper, we investigate the causes and consequences of such changes in the banks behaviors, by introducing the bank’s asset portfolio decision into an otherwise standard New Keynesian model. The banks in our model construct their portfolio under the value at risk constraint, that requires banks repay their debt regardless of the realization of the asset returns. Under the constraint, an increase in down-side risks, tightening of capital requirement rules or deterioration of the banks net worth reduce the banks’ risk taking capacity, and incurs a shrinkage of the bank’s balance sheet and asset rebalancing towards government bond. The changes in banks’ investment decisions dampen output and inflation. Empirical studies suggest that our theoretical predictions are consistent with behavior of the Japanese banks.