Why Are Banks Not Recapitalized During Crises?

Matteo Crosignani

(August 2015)
ONB Working Paper no. 203

- Eleventh Klaus Liebscher Award, 2015

Summary: During sovereign crises, governments might value undercapitalized domestic banks. These institutions risk-shift buying domestic sovereign bonds, effectively acting as buyers-of-last-resort for the home sovereign

Abstract: I develop a model where governments might prefer undercapitalized domestic financial sectors during crises. Weak banks optimally tilt their sovereign bond portfolio towards domestic securities that are positively correlated with banks’ other revenue sources. Governments anticipate this gambling-for-resurrection motive and 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 data support the proposed mechanism as high leverage banks drove the increase in domestic government bond holdings during the recent crisis.