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Financial Risk Capacity†

Financial Risk Capacity† AbstractFinancial crises are particularly severe and lengthy when banks fail to recapitalize after bearing large losses. We present a model that explains the slow recovery of bank capital and economic activity. Banks provide intermediation in markets with information asymmetries. Large equity losses force banks to tighten intermediation, which exacerbates adverse selection. Adverse selection lowers bank profit margins, which slows both the internal growth of equity and equity injections. This mechanism generates financial crises characterized by persistent low growth. The lack of equity injections during crises is a coordination failure that is solved when the decision to recapitalize banks is centralized. (JEL D82, E32, E44, G01, G21, G32, L25) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Journal Macroeconomics American Economic Association

Financial Risk Capacity†

American Economic Journal: Macroeconomics 2021, 13(4): 142–181 https://doi.org/10.1257/mac.20160286 By Saki Bigio and Adrien d’Avernas* Financial crises are particularly severe and lengthy when banks fail to recapitalize after bearing large losses. We present a model that explains the slow recovery of bank capital and economic activity. Banks provide intermediation in markets with information asymme- tries. Large equity losses force banks to tighten intermediation, which exacerbates adverse selection. Adverse selection lowers bank profit margins, which slows both the internal growth of equity and equity injections. This mechanism generates financial crises characterized by persistent low growth. The lack of equity injections during crises is a coordination failure that is solved when the decision to recapitalize banks is centralized. (JEL D82, E32, E44, G01, G21, G32, L25) inancial crises that originate from extreme bank losses are severe in depth and F These episodes suggest that the recapitalization of banks is critical for duration. the recovery of overall economic activity. After the recent financial crisis, the slow recovery of bank equity has been a major concern for policymakers, academics, and When the then Chairman of the Federal Reserve, Ben Bernanke, was practitioners. asked when the crisis would be over, he answered, “When banks start raising capital But why do banks struggle to recapitalize after a financial crisis? on their own.” To answer this question, macroeconomic theory introduces frictions that prevent banks from raising equity or barriers to entry that deter the creation of new banks. This explains why banks do not recapitalize but does not rationalize why banking crises last so long. To explain slow recoveries, any theory must also rely on low profit margins from intermediation after banks suffer equity losses. Otherwise, high profit * Bigio: Department of Economics, University of California, Los Angeles (email:...
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References (113)

Publisher
American Economic Association
Copyright
Copyright © 2021 © American Economic Association
ISSN
1945-7715
DOI
10.1257/mac.20160286
Publisher site
See Article on Publisher Site

Abstract

AbstractFinancial crises are particularly severe and lengthy when banks fail to recapitalize after bearing large losses. We present a model that explains the slow recovery of bank capital and economic activity. Banks provide intermediation in markets with information asymmetries. Large equity losses force banks to tighten intermediation, which exacerbates adverse selection. Adverse selection lowers bank profit margins, which slows both the internal growth of equity and equity injections. This mechanism generates financial crises characterized by persistent low growth. The lack of equity injections during crises is a coordination failure that is solved when the decision to recapitalize banks is centralized. (JEL D82, E32, E44, G01, G21, G32, L25)

Journal

American Economic Journal MacroeconomicsAmerican Economic Association

Published: Oct 1, 2021

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