Bank Bailouts Justified to Minimize Economic Costs
The recent banking bailouts get some academic underpinning in a new working paper from the International Monetary Fund.
“Banking bailouts in periods of significant financial distress may be justified to avoid an economically costly and persistent credit crunch,” the paper finds.
While not official IMF policy, the paper by Fabien Valencia suggests that the financial health of the banking system may be a significant contributor to the propagation of economic shocks, especially negative ones. “Banks’ precautionary motive insulates lending from shocks up to some size, but for larger shocks the economic consequences of the ensuing credit crunch may be significant.”
The paper develops a bank model to study credit crunches and their real effects. In the model, banks maintain a precautionary level of capital that serves as a smoothing mechanism to avert disruptions in the supply of credit when hit by small shocks. “However, for larger shocks, highly persistent credit crunches may arise even when the impulse is a one time, non-serially correlated event.”
From a policy perspective, the model justifies the use of public funds to recapitalize banks following a significant deterioration in their capital position.
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