Costs of Adjustment, Portfolio Separation, and the Dynamic Behavior of Bank Loans and Deposits

In this paper we develop a model of the banking firm that enables us to test for portfolio separation. Our theoretical model generalizes existing intertemporal adjustment-cost models by assuming that these costs coexist simultaneously on both sides of the bank's balance sheet. The optimal deposit supply and loan demand functions that emerge from our extended model show that each of these functions depends both on one- and two-period quantity lags and the lagged, contemporaneous, and expected future values of interest rates, including loan, deposit, and short term borrowing (for example, federal funds) rates. Models exhibiting portfolio separation or asset-liability independence emerge as a special case of the extended model. This feature enables us to test conditions, paralleling those first highlighted by Sealey (1985), that are consistent with the portfolio separation hypothesis. When portfolio separation holds, deposit supply and loan demand depend only on a one period quantity lag and contemporaneous and expected future differentials of the own rate and the federal funds rate. Thus, the property of portfolio separation can be examined empirically by determining whether the zero restrictions required by that property are supported in the econometric estimates of the banks' deposit supply and loan demand functions