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Financial Risk Capacity

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  • Saki Bigio

    (Columbia Business School)

Abstract

Financial crises seem particularly severe and lengthy when banks fail to recapitalize after large losses. I explain this failure and the consequent depth of financial crises through a model in which banks provide intermediation in markets with informational asymmetries. Large equity losses reduce a bank's capacity to bear further losses. Losing this capacity leads to reductions in intermediation and exacerbates adverse selection. Adverse selection, in turn, lowers profits from intermediation, which explains the failure to attract equity injections or retain earnings quickly. Financial crises are infrequent events characterized by low economic growth that is overcome only as banks slowly recover by retaining earnings. I explore several policy interventions.

Suggested Citation

  • Saki Bigio, 2014. "Financial Risk Capacity," Working Papers 2014-22, Peruvian Economic Association.
  • Handle: RePEc:apc:wpaper:2014-022
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    3. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2019. "Credit Supply and the Housing Boom," Journal of Political Economy, University of Chicago Press, vol. 127(3), pages 1317-1350.
    4. Neuhann, Daniel, 2016. "Macroeconomic effects of secondary market trading," ESRB Working Paper Series 25, European Systemic Risk Board.
    5. Zhiguo He & Arvind Krishnamurthy, 2019. "A Macroeconomic Framework for Quantifying Systemic Risk," American Economic Journal: Macroeconomics, American Economic Association, vol. 11(4), pages 1-37, October.
    6. Gertler, M. & Kiyotaki, N. & Prestipino, A., 2016. "Wholesale Banking and Bank Runs in Macroeconomic Modeling of Financial Crises," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 1345-1425, Elsevier.
    7. Mark Gertler & Nobuhiro Kiyotaki, 2015. "Banking, Liquidity, and Bank Runs in an Infinite Horizon Economy," American Economic Review, American Economic Association, vol. 105(7), pages 2011-2043, July.
    8. House, Christopher L. & Masatlioglu, Yusufcan, 2015. "Managing markets for toxic assets," Journal of Monetary Economics, Elsevier, vol. 70(C), pages 84-99.
    9. Neuhann, Daniel, 2017. "Macroeconomic effects of secondary market trading," Working Paper Series 2039, European Central Bank.
    10. Lawrence J. Christiano & Roberto Motto & Massimo Rostagno, 2014. "Risk Shocks," American Economic Review, American Economic Association, vol. 104(1), pages 27-65, January.
    11. Fukui, Masao, 2018. "Asset Quality Cycles," Journal of Monetary Economics, Elsevier, vol. 95(C), pages 97-108.
    12. Francesco Ferrante, 2015. "Risky Mortgages, Bank Leverage and Credit Policy," Finance and Economics Discussion Series 2015-110, Board of Governors of the Federal Reserve System (U.S.).
    13. Joseph Mullins & Gaston Navarro & Julio Blanco, 2013. "Equilibrium Default and Slow Recoveries," 2013 Meeting Papers 694, Society for Economic Dynamics.
    14. Gaston Navarro & Julio Blanco, 2016. "Equilibrium Default and the Unemployment Accelerator," 2016 Meeting Papers 1502, Society for Economic Dynamics.

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    More about this item

    Keywords

    Financial Crisis; Adverse Selection; Capacity Constraints;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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