Working Paper: NBER ID: w26561
Authors: Saki Bigio; Adrien Davernas
Abstract: 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.
Keywords: No keywords provided
JEL Codes: E32; E44; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Large equity losses (G12) | Tighter bank intermediation (G21) |
| Tighter bank intermediation (G21) | Increased adverse selection (D82) |
| Reduced profit margins (L11) | Inhibited banks' ability to raise equity (G21) |
| Coordination of equity injections (G33) | Improved profit margins (L21) |
| Improved profit margins (L21) | Recovery of economic activity (E65) |
| Low net worth in the banking sector (G21) | Strong adverse selection (D82) |
| Strong adverse selection (D82) | Low profit margins (D49) |
| Low profit margins (D49) | Prolonged crisis (H12) |