Undercapitalized Banks, Uncertain Government Policies, and Declines in Total Factor Productivity

Recently a number of countries have experienced a prolonged slowdown in aggregate economic activity accompanied by a signi.cant deterioration of the banks.net worth. This paper studies the optimal bank behavior when they are severely undercapitalized but continue to operate due to lax government policies. In particular, we show that when the government policies generate uncertainties regarding (i) the exact timing at which the government intervention will occur, and (ii) the fraction of the banks that will be forced to shut down, then banks change their lending behavior. These changes are largely responsible for the prolonged recession, which occurs in the aftermath of the banking crisis. The mechanism through which this e¤ect occurs is as follows. In the model economy, .rms need .time to build.in order to achieve the maximum return on investment they undertake. Due to the uncertainty regarding the probability of survival, the banks. discount rate increases dramatically. This implies that the banks do not wish to .nance long-term investment, forcing .rms to switch to the short-term projects. These projects do not require .time to build., but are less productive. As the quality of investment falls, the total factor productivity (TFP) falls, contributing to the fall in aggregate output. Such a joint decline in the TFP and aggregate output in the aftermath of the banking crisis is a salient feature of the Japan.s and Mexico.s recent experiences.