Bank failures and fiscal austerity: policy prescriptions for a developing country

Abstract

This work employs a dynamic general equilibrium model to evaluate the causes and implications of bank insolvencies. We apply the model to stylized data from Bangladesh, a country whose banking system is currently suffering from large stocks of non-performing assets. The model is used to derive positive conclusions about alternative policy instruments designed to alleviate the impact of these insolvencies. A benchmark case is simulated using historical exogenous parameters. We then generate a bank failure by assuming that firms cannot service their debt if their interest obligations rise above their anticipated return on capital. The public withdraws deposits from the banking system in reaction to worries about defaulting bank assets. If banks optimize by restricting credit to risky borrowers, these failures can be partially avoided. Such bank behavior is often prohibited in developing countries, so we investigate an active monetary policy that compensates banks for withdrawn deposits. The resulting outcome indicates that such a policy can slow the pace of bank failures, although at the cost of certain macro imbalances. Our final simulation imposes a reduction in public spending in order to tighten fiscal policy and thereby reduce budgetary pressure. The resulting decline in interest rates eliminates all investor defaults and bank failures. We conclude that the combination of compensating monetary policy and restrictive fiscal policy may offer the best way of responding to a bank crisis.