A Q-Theory of Banks
The Great Recession in 2009 forced researchers and policy-makers to rethink regulations of the financial system. There has been a renewed effort to understand the behaviour of banks, their objectives and constraints, and their role in the economy. This paper contributes to that end by studying how banks react to changes in the value of their assets (generated, for example, by defaults on their loans).
We argue that it is important to distinguish between the book value of loans (what policy-makers use in their regulations) and the market value of loans (what investors perceive these loans to be worth). Book values are slow to recognize losses, and this gives banks leeway in terms of the regulations they must comply with. Market values provide additional information about the profitability of these loans.
Should regulators aim to have banks recognize changes in the value of their assets as soon as they materialize? We show that such a policy could be counterproductive: it would more efficiently enforce regulatory requirements, but at the cost of forcing banks to more sharply adjust their loans during recessions to meet these regulations.