Financial Risk Capacity

57 Pages Posted: 16 Dec 2019 Last revised: 15 Oct 2021

See all articles by Saki Bigio

Saki Bigio

University of California, Los Angeles (UCLA) - Department of Economics

Adrien d'Avernas

Swedish House of Finance

Date Written: December 2019

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.

Suggested Citation

Bigio, Saki and d'Avernas, Adrien, Financial Risk Capacity (December 2019). NBER Working Paper No. w26561, Available at SSRN: https://ssrn.com/abstract=3504446

Saki Bigio (Contact Author)

University of California, Los Angeles (UCLA) - Department of Economics ( email )

8283 Bunche Hall
Los Angeles, CA 90095-1477
United States

Adrien D'Avernas

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

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