Financial Intermediation, Capital Accumulation and Crisis Recovery

Abstract

We integrate bank and bond financing into a two-sector neoclassical growth model to examine the stabilization effect of endogenous bank leverage adjustment. We show that although bank leverage amplifies shocks, the increase of leverage to a decline in bank equity is an automatic stabilizer in downturns, since it partially offsets the decline of bank lending to financially constrained firms. Regulatory capital limits and wage rigidities impair the re-allocation of capital between sectors and weaken the automatic stabilization channel. A quantitative analysis of the US in the Great Recession shows that the magnitude of automatic stabilization is significant and informs about potentially high costs of strict capital regulation or wage rigidities in banking crises.

Keywords: financial intermediation, capital accumulation, banking crises, macroeconomic shocks, business cycles, bust-boom cycles, managing recoveries

JEL Classification: E21, E32, F44, G21, G28