Recapitalization, Bailout, and Long-run Welfare in a Dynamic Model of Banking

54 Pages Posted: 16 Oct 2020 Last revised: 22 Jan 2021

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Date Written: October 14, 2020

Abstract

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

Modena, Andrea, Recapitalization, Bailout, and Long-run Welfare in a Dynamic Model of Banking (October 14, 2020). SAFE Working Paper No. 292, Available at SSRN: https://ssrn.com/abstract=3712211 or http://dx.doi.org/10.2139/ssrn.3712211

Andrea Modena (Contact Author)

University of Bonn ( email )

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