Financial Risk Capacity
Saki Bigio and
No 26561, NBER Working Papers from National Bureau of Economic Research, Inc
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 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-codes: E32 E44 G01 G21 (search for similar items in EconPapers)
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