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The recapitalisation of distressed banks by governments can substantially reduce the length of a recession. Such banks, moreover, return to financial health more quickly than distressed banks without sufficient capital support. These are the findings of research conducted by Timotej Homar, who will obtain his doctorate from the UvA on Wednesday, 10 February.

Chris Potter (Flickr CC)
Chris Potter (Flickr CC)

Systemic banking crises can have severe consequences and are often followed by long recessions. During such crises, governments and central banks actively intervene in order to preserve financial stability and limit output losses. Until now, however, there has been vociferous debate about the efficacy of such measures, especially recapitalisation (government-funded support), which has of late drawn wide-spread public criticism. Recent examples of undercapitalised banks receiving such support include the Royal Bank of Scotland and Dutch bank ABN Amro.

Reducing recession

For his dissertation, Homar analysed intervention measures by governments and central banks on both a macro and micro level. At the macro level, Homar investigated how different measures affect the duration of recessions while at the micro level his focus was on the effects of bank recapitalisations on bank lending, funding and asset quality.  

By sourcing and comparing data from various governmental and financial entities, including the IMF and the European Commission, Homar found that recessions tend to last longer when distressed banks continue to operate despite being undercapitalised. ‘Such banks are likely to turn into zombie banks that ration credit to new borrowers but continue to renew loans to insolvent borrowers to delay recognition of losses. This leads to an inefficient allocation of resources and manifests itself in longer recessions’, says Homar. ‘I find that recapitalising distressed banks considerably mitigates these problems and reduces the expected recession duration by almost half. Other measures, such as liquidity support and guarantees on bank liabilities seem to be less effective.’

A clean balance sheet

Besides preventing a protracted recession, recapitalised banks also return to financial health quicker, says Homar. ‘When a distressed bank is recapitalised, it increases lending, attracts more deposits and is able to borrow more on the interbank market. It also cleans up its balance sheet.’ These effects, Homar points out, are only present if the recapitalisation amount is large enough. ‘Banks that receive a small recapitalisation relative to their capital shortfall respond differently: they reduce lending and shrink assets, presumably to improve their capital ratio, and also experience an outflow of deposits.’

Despite being effective at reducing the length of recessions related to banking crises, the costs and benefits of recapitalisation still warrants further analysis, says Homar. ‘Although I didn’t explicitly compare the costs and benefits, it is reasonable to assume that if the duration of a recession is reduced because of recapitalisation and higher growth then ensues, tax revenues will also increase, thereby offsetting the costs of this measure. Moreover, if done smartly, governments also stand to profit from the investment they make by supporting undercapitalised banks.’

Details

Timotej Homar, Intervention in Systemic Banking Crises. Supervisors: Professor A.W.A. Boot and Professor S.J.G. van Wijnbergen.

Time and location

The doctoral thesis defence ceremony will take place on Wednesday, 10 February at 12:00. Location: Agnietenkapel, Oudezijds Voorburgwal 229, Amsterdam