Abstract
What are the quantitative effects of a government infused bank recapitalization in response to loan defaults? We analyze two different scenarios of government infused recapitalization using a dynamic stochastic general equilibrium (DSGE) model, calibrated to an emerging market economy with state owned banks. The first is an unconditional transfer and the second is an “equity in exchange for transfer” to banks. We show that a government infused recapitalization in response to a negative productivity shock may increase output in the short run. However, there is welfare loss, which is higher in the case of unconditional transfers. Our analysis suggests that bank recapitalization facilitates credit creation, capital formation and growth, especially during a cyclical downturn. There is however a need for appropriate policy vigil to protect the quality of public expenditure in the social sector that matters for welfare in the long run.
Highlights
The global financial crisis (2008) underlined the pivotal role of the banking sector in advanced and emerging market economies and brought to fore some of the limitations of the existing international banking regulations
What are the quantitative effects of a government infused bank recapitalization in response to loan defaults? We analyze two different scenarios of government infused recapitalization using a dynamic stochastic general equilibrium (DSGE) model, calibrated to an emerging market economy with state owned banks
Our analysis suggests that bank recapitalization facilitates credit creation, capital formation and growth, especially during a cyclical downturn
Summary
The global financial crisis (2008) underlined the pivotal role of the banking sector in advanced and emerging market economies and brought to fore some of the limitations of the existing international banking regulations (see BIS Paper No 60, 2018 [1]). There is, a trade-off, with the government bank recapitalization plan This could result in rationalization of the government’s capital investment and other social expenditures, which might in turn have an adverse impact on the long-run economic growth and welfare. In terms of fiscal costs, these large infusions have reinvigorated the debate on whether such measures would crowd-out other productive spending and thereby adversely impact welfare This is important in the context of EMEs such as India, which are on a fiscal consolidation path, and the share of capital expenditure is already small in overall expenditures. Recapitalization measures crowd-out social sector spending, which we model as utility enhancing government expenditures This could have an adverse impact on overall welfare.
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