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

This paper develops a model of the banking firm and tests for the presence of 'portfolio separation.' The theoretical model generalizes existing intertemporal adjustment-costs models by assuming that these costs coexist simultaneously on both sides of the bank's balance sheet. Our analysis predicts that bank loan demand and deposit supply respond to past, current and expected fixture values of the federal funds rate, deposit rate, and loan rate. We estimate the model and find that the restrictions imposed by the portfolio separation assumption are inconsistent with the estimated behavior of the banking firms in our sample. We also find some limited empirical support for our extended model of the adjustment cost process. Copyright 1995 by Ohio State University Press.