Household Default, Capital Constrained Large Banks, and Selective Spillovers

Abstract

Our analysis reveals that banks could develop capital-constrained by holding nonperforming household debts supported by central bank liquidity. We demonstrate the sequential responses to nonperforming assets on retained earnings, capital reserve, and new equity issuance. With capital reserves, banks can keep adding risky assets when retained earnings lag. Running low, banks have to downsize and issue new equity. We document market predictions on firms’ exposure before a systemic event: large banks collectively reduced their debt supply in 2009. Practicing selectively and collectively downsizing, banks prioritize clients on historical revenue contribution. Borrowers with exclusive relationships report lower risk exposure.