Bank Capital, Bank Credit and Unemployment

Since the worst employment slumps follow periods of high household debt and almost all household debt is provided by banks, there is a natural link between bank lending and employment. Building on this, we theoretically investigate whether bank regulation can play a role in stimulating employment. Using a competitive search model, we find that levered households suffer from a debt overhang problem that distorts their preferences, making them demand high wages. In general equilibrium, firms internalize these preferences and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment. Unemployed households default on their debt. In equilibrium, the level of household debt is inefficiently high due to a household-debt externality--banks fail to internalize the effect that household leverage has on household default probabilities via the vacancy-posting effect. As a result, household debt levels are inefficiently high. Our results suggest that a combina- tion of loan-to-value caps for households and capital requirements for banks can elevate employment and improve efficiency, providing an alternative to monetary policy for labor market intervention.