FINANCIAL RISK CAPACITY

Saki Bigio1 Financial crises seem particularly lengthy when banks fail to recapitalize after large losses. I explain this through a model where 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 which is overcome only as banks slowly recover by retaining earnings. Several policy interventions are explored