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

Abstract

This paper studies the dynamic trade-off between the short-run costs and the long-run benefits of bank bailouts. In the model, banks leverage thanks to their cost advantage at monitoring firms, but hold precautionary capital buffers to avoid costly equity issuance after negative shocks. Banks' recapitalization is sub-optimal because they do not internalize the positive externalities of the banking sector's relative size on their individual leverage capacity and firms' investments. Systematic bailouts can help improving the allocation efficiency in bad states, in which banks' leverage is persistently constrained and investments are low. In the long run, bailouts accelerate the economy recovery path by fostering growth, thereby reducing endogenous risk.