Recapitalization in an Economy with State-Owned Banks—A DSGE Framework

Abstract

What are the quantitative effects of a government infused bank recapitalization in response to loan defaults? We analyze two different scenarios of government infused recapitalization using a dynamic stochastic general equilibrium (DSGE) model, calibrated to an emerging market economy with state owned banks. The first is an unconditional transfer and the second is an “equity in exchange for transfer” to banks. We show that a government infused recapitalization in response to a negative productivity shock may increase output in the short run. However, there is welfare loss, which is higher in the case of unconditional transfers. Our analysis suggests that bank recapitalization facilitates credit creation, capital formation and growth, especially during a cyclical downturn. There is however a need for appropriate policy vigil to protect the quality of public expenditure in the social sector that matters for welfare in the long run.