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.
Bigio, Saki, and Adrien d'Avernas.
"Financial Risk Capacity."
American Economic Journal: Macroeconomics,
Asymmetric and Private Information; Mechanism Design
Business Fluctuations; Cycles
Financial Markets and the Macroeconomy
Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
Firm Performance: Size, Diversification, and Scope