Financial Crises and Recapitalizations

Authors

  • DAMIANO SANDRI,

  • FABIÁN VALENCIA


  • The views expressed in the paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Previously circulated under the title “Balance-Sheet Shocks and Recapitalizations.” The authors thank Christopher Carroll, Stijn Claessens, Giovanni Dell'Ariccia, Gregory de Walque, Luc Laeven, Jose Luis Peydro, Jose Victor Rios-Rull, the editors Kenneth West and Robert Kollmann, two anonymous referees, and seminar participants at the NBER Summer Institute, the IMF, the CEPR-EBC-HEC-NYSE/Euronext-RoF Conference on “Financial Intermediation and the Real Economy,” the National Bank of Poland's conference “DSGE and Beyond,” and CEPR-National Bank of Belgium-JMCB-ECARES-Ghent University conference on “Macroeconomics and Financial Intermediation” for comments and discussions.

Abstract

We develop a dynamic stochastic general equilibrium model with financial frictions on both financial intermediaries and goods-producing firms. Since financial intermediaries are highly leveraged, we show that the welfare gains from their recapitalization in response to large but rare net worth losses are as large as those from eliminating typical business cycle fluctuations. We also find that these gains are increasing in the size of the net worth loss, are larger when recapitalization funds are raised from the household rather than the real sector, and can be larger when lower idiosyncratic risk leads to higher leverage.

Ancillary