Financial Intermediation, Capital Accumulation, and Recovery

Abstract

This paper integrates a simple model of banks into a two-sector neoclassical growth model. The integration yields an analytically tractable framework with two coupled accumulation rules for household capital and bank equity. We analyze steady state properties, transition and recovery patterns, as well as policies to accelerate recoveries. After establishing existence, uniqueness and global stability of the steady state, we identify in particular five key results and predictions, and we provide a quantitative assessment. First, larger financial frictions in financial intermediation may increase banker wealth although total capital is depressed. Second, negative shocks to bank equity cause considerably larger downturns than comparable shocks to household wealth, but their persistence is similar. Third, temporary worsening of shocks to financial frictions (called "trust shocks") induces divergent reactions of household wealth and bank equity, causes a boom in the banking sector, and possibly in the economy – after an initial bust. Fourth, the model replicates typical patterns of financing over the business cycle: procyclical bank leverage, procyclical bank lending, and counter-cyclical bond financing. Finally, a combination of bailouts and dividend-payout-restrictions ensures a rapid build-up of bank equity after a slump in the banking sector and increases total production.