Bank leverage, credit traps and credit policies

We construct an overlapping generations macroeconomic model with which to study the causes, consequences and remedies to ‘credit traps’ — prolonged periods of stagnant real activity accompanied by low productivity, financial sector undercapitalisation, and the misallocation of credit. In our model, credit traps arise when shocks to bank equity capital tighten banks’ borrowing constraints, causing them to allocate credit to easily collateralisable but low productivity projects. Low productivity weakens bank capital generation, reinforcing tight borrowing constraints, sustaining the credit trap steady state. We use the model to study policy options, both ex ante(avoiding credit traps) and ex post (escaping them). Ex ante, restrictions on bank leverage can help to enhance the economy’s resilience to the shocks that can cause credit traps. Further, a policymaker focused on maximising the economy’s resilience to credit traps would set leverage countercyclically, allowing an expansion of leverage in minor downturns and reducing leverage in upswings. However, ex post, relaxing a leverage cap will not help escape the trap. Instead, a range of unconventional policies are needed. We study publicly intermediated lending, discount window lending, and recapitalisation, and compare the efficacy of these policies under different conditions.