Recapitalization, Bailout, and Long-run Welfare in a Dynamic Model of Banking
54 Pages Posted: 16 Oct 2020 Last revised: 22 Jan 2021
Date Written: October 14, 2020
This paper studies the link between bank recapitalization and welfare in a dynamic production economy. The model features financial frictions because banks benefit of a cost advantage at monitoring firms and face costly equity issuance. The competitive equilibrium outcome is inefficient because agents do not internalize the effects banks’ capitalization over the allocation of capital, its price and, in turn, firms investments. It follows, individual recapitalizations are sub-optimal and bailout policies may benefit social welfare in the long-run. Bailouts improve capital allocation in states where aggregate banks are poorly capitalized, therefore enhancing their market valuation, fostering investments, and stabilizing the economy recovery path.
Keywords: Banks, bailout, general equilibrium, financial frictions, recapitalization, welfare
JEL Classification: D51, G21
Suggested Citation: Suggested Citation