Why are Banks Not Recapitalized During Crises?

Abstract

I develop a model where governments might prefer to have an undercapitalized domestic financial sector during crises. Weak banks optimally tilt their sovereign bond portfolio towards domestic securities that are positively correlated with banks’ other sources of revenues. Governments anticipate this gambling-forresurrection motive and therefore face a trade-off when setting capital regulation. Undercapitalized banks act as buyers of last resort for home public debt at the cost of crowding-out private lending. Following recapitalizations, governments may face lower debt capacity and higher sovereign yields. European stress test data support the proposed mechanism as high leverage banks increased domestic government bond holdings relative to low leverage banks during the crisis. The general equilibrium model can rationalize, in the context of the Eurozone periphery, the increased banks’ holdings of domestic public debt, the ecreasing private lending, and the prolonged undercapitalization of the banking sector.