EMANUEL BARNEA MOSHE KIM Dynamics of Banks’ Capital Accumulation We construct a dynamic neoclassical model of banking capital where the dynamics are governed by the process of financial capital accumulation and credit risk realizations in a structure where stylized banking characteristics are maintained. This is aimed at focusing on how the profit-maximizing cap- ital ratio of banks evolves and how it reacts to exogenous shocks particularly so during periods of prolonged downturn of the economy. We examine im- pulse responses of our model to credit risk shock, business cycle shock, and monetary policy shock. The convergence of financial capital to its optimal level is also explored. JEL codes: G20, G21, G28 Keywords: financial capital accumulation, moral hazard, market discipline, adverse selection, monitoring. HOW LONG DOES IT take for the stock of bank’s financial capital to return to its optimal level following a negative shock, and what is the mechanism that governs its dynamics? These issues become particularly relevant for the aftermath of the recent financial crisis and possible subsequent developments. To explore these issues, we construct a dynamic neoclassical model of banking capital where the dynamics are governed by the process of financial capital accumulation and credit risk realizations. This is aimed at focusing on how the profit-maximizing capital ratio of banks evolves and how it reacts to exogenous shocks particularly so during periods of prolonged downturn of the economy. Additionally, when shocks hit the financial system, in particular the banking sector, it propagates business cycles (Reinhart and Rogoff 2009). However, bank capital is absent from most of the recent contributions in developing dynamic stochastic general equilibrium (DSGE) models with financial frictions implying that bank lending is We thank two anonymous referees for many constructive comments, and Robert DeYoung, the editor, for his most helpful insights. EMANUEL BARNEA is Head of Banking Research at Bank of Israel (E-mail: emanuel.barnea@boi.org.il). MOSHE KIM is a Professor of Economics at University of Haifa and Professor at NYU Shanghai (E-mail: kim@econ.haifa.ac.il). Received August 17, 2011; and accepted in revised form April 8, 2013. Journal of Money, Credit and Banking, Vol. 46, No. 4 (June 2014) C  2014 The Ohio State University