Banking on Buffers: Balance Sheet Responses to Household Demand, Macroeconomic Conditions, and Monetary Policy

This paper examines how banks adapt to tightening regulations, evolving macroeconomic conditions, and changes in household demand. Unlike most analyses of banking regulation, we develop a general equilibrium model in which banks both borrow from and lend to households, allowing us to assess the impact of regulations in conjunction with other macroeconomic factors. The model features an often overlooked interplay between household portfolio choices and bank financial decisions, emphasizing the contribution of household preferences to the precipitous climb in cash ratios that accompanied reductions in bank leverage following the 2008 global financial crisis. Through counterfactual analysis, we find that in the absence of heightened household demand for deposits, decline in bank leverage would have been twice as steep, and the proportion of mortgage loans within total assets would have contracted by more than twice the actual post-crisis change. Our empirical analysis confirms the increase in household demand for deposits and explores how this expansion interacts with banks' capital buffers. The empirical results support our comparative static implications that banks with larger capital buffers accumulate less cash and more mortgages as a share of total assets than banks with smaller capital buffers in response to growing deposits. The mechanisms discussed in this study are pertinent for policymakers, particularly as central banks worldwide consider further interest rate reductions and U.S. regulators finalize the implementation of Basel III requirements.