Debt Deflation and Bank Recapitalization

During some recent financial crises, the majority of domestic banks -or indeed the entire banking sector- became insolvent. We have analyzed the welfare effects of policy responses to bank insolvency by examining a modified version of the Diamond-Rajan model, introducing a fiat currency. The sources of inefficiency in our model are the "moral hazard in banking" and the "premature liquidation of bank assets". The model assumes that banking system insolvency is caused by an exogenous macroeconomic shock that destroys a portion of banks' assets.

If the government does not intervene in very severe cases of bank insolvency, a fire sale of all bank assets can occur along with dis-intermediation of the economy and falls in price levels (debt deflation).

We have analyzed the consequences of the following three different policy responses to bank insolvency: (1) providing deposit guarantees (without immediate recapitalization), (2) providing unlimited liquidity support, and (3) effecting bank recapitalization through either cash creation (monetary policy) or bond issuance (fiscal policy). In doing so, we showed that bank recapitalization by fiscal measures provides the optimal solution. Our findings imply that Japan's protracted recession and deflation problem may have been caused by an inappropriate policy response to bank insolvency.