XXV Edition

1-2 December 2016"

Fire Sale Bank Recapitalizations

Mariathasan Mike, KU Leuven
Bertsch Christoph, Sveriges Riksbank

We develop a general equilibrium model of banks’ capital structure, featuring an imperfectly elastic supply of equity stemming from financial market segmentation. Banks are ex-ante identical. When selecting their equity buffer, they trade off an endogenous wedge between the cost of equity and debt with better protection from bankruptcy. Expost, portfolio risk is heterogeneous and banks may need to recapitalize. When a capital short-fall simultaneously arises in a large number of banks, the market for equity becomes crowded and the elevated cost of issuing new shares dilutes old shareholders’ claims. Reminiscent of asset fire sales, banks do not fully internalize the effect of their individual equity issuance on the endogenous cost of equity and -importantly- on their future ability to recapitalize. Provided higher initial equity buffers are associated with a reduction in the future equity issuance volume, banks are under-capitalized in equilibrium, and the incidence of insolvency is inefficiently high. This constrained inefficiency provides a new rationale for macro-prudential capital regulation that arises despite the absence of deposit insurance and moral hazard; it is also relevant for the regulation of payout policies and the communication of stress test results.

Area: Banking

Keywords: Macroprudential policy, capital regulation, capital structure, financial market segmentation, incomplete markets, constrained inefficiency.

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