Abstract: A Theory of the Impact of Monetary and Regulatory Policy on Bank Portfolio Composition

A two period model of bank behavior is developed where the bank chooses, at the beginning of period one, optimal levels of loans, securities and debt. Given perfectly illiquid loans, perfectly liquid securities investments, and alternative assumptions about the liquidity and cost of debt, the bank chooses the endogenous variables as follows: (1) If the marginal cost of borrowing everywhere exceeds the marginal return to securities then: a) near the trough of the loan demand cycle marginal returns on securities and loans are equated and debt is zero; b) in the center of the loan demand cycle all deposits are committed to loans as their marginal return exceeds the marginal return on securities but is less than the marginal cost of debt; c) near the peak of the business cycle securities are zero and non-deposit liabilities are acquired until their marginal cost is equal to the marginal return on loans. (2) If the marginal cost of borrowing is, in some range, less than the marginal return to securities, then instead of possibility b) above, the bank will borrow to finance both loans and securities as a precaution against the prospect of future borrowing at a higher cost.