Balance Sheet Adjustment and Monitoring With and Without a Capital Constraint

ABSTRACT This paper analyses loan monitoring and balance sheet management by a bank under unconstrained and constrained (binding capital‐asset ratio) profit maximization. The loan‐deposit spread plays a pivotal role in bank behaviour only in the unconstrained case. Following a loss of capital, a capital‐unconstrained bank perfectly insulates its loan portfolio by a matching increase of deposits, so long as the marginal cost of raising additional deposits is constant or zero. In this case, a bank's monitoring is not affected by a loss of capital either. In sharp contrast, a loss of capital causes a capital‐constrained bank's monitoring to increase while both deposits and loans shrink substantially. Balance sheet adjustment and monitoring thus vary dramatically, depending on the capital position of the bank relative to prescribed requirements.