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Sweder van Wijnbergen and Timotej Homar show how the duration of the recession could be cut in half if the right measures are taken. Now the government is stimulating the formation of zombie banks.

Photo Sweder van Wijnbergen

European Central Bank 

The research carried out by Sweder van Wijnbergen and Timotej Homar was recently cited in a speech made by Benoît Coeuré, board member of the European Central Bank.

Governments intervene during financial crises, not just to preserve the key functions of the financial system, but often also to mitigate their macroeconomic impact. Sweder van Wijnbergen and Timotej Homar show that the way governments deal with zombie banks has a major impact on the duration of recessions that follow most systemic banking crises. Van Wijnbergen: “A bank becomes a zombie bank when it experiences a large drop in asset value. Banks typically try to delay recognition of such losses. A zombie bank prefers to wait for better news rather than writing off bad loans and freeing up resources for new loans.  Gambling on bad loans in general means funding inefficient or even insolvent firms. On the macro level this means a longer recession.” 

The researchers compare two groups of policy interventions, under the headings liquidity provision and recapitalization. The first group consists of deposit insurance, blanket guarantees on bank liabilities and direct liquidity provision by the central bank. They prevent bank failures, but maintain the incentives to hang on to bad loans. In contrast to guarantees and liquidity support an early and large enough bank recapitalization improves bank incentives for managing bad loans. The purpose of recapitalization is to bring the bank equity to a level where the bank again behaves as a prudent bank. When a bank is recapitalized, it will lend again to productive firms. This will accelerate the recovery.

Van Wijnbergen and Homar investigate in their empirical analysis the duration of recessions after 65 systemic banking crises from 1980 until now.  Homar: “The challenge in such estimation is the endogeneity of policies to crisis severity, which is unobserved, but in severe crises different policies tend to be used than in mild crisis. Using a panel dataset, with data about intervention in each quarter of a recession enables us to estimate the effect of intervention that is not correlated to unobserved crisis severity. We model recession duration as a process that can end each quarter. The probability of recovery in each quarter depends on the crisis severity, the time the recession has already lasted and the policies used. We use an approach that enables us to estimate the size of crisis severity as a fixed effect in a duration model and allows variables describing intervention to be correlated with it. The estimates of the effect of intervention are based only on the component that is not correlated with crisis severity.”

Van Wijnbergen and Homar find that bank restructuring programs with recapitalizations significantly increase the probability of recovery. Providing liquidity support also increases probability of recovery but the effect is not as large as for bank recapitalizations. Blanket guarantees on bank liabilities and monetary expansion do not have a significant effect on probability of recovery. Translating expected exit probabilities into a measure of expected recession duration, our results imply that early recapitalization of troubled banks reduces the expected duration of recessions by at least 50%. 

Just keeping banks alive by providing them with guarantees and liquidity only, the current practice in Europe, thus leads to a significantly longer recession than would have been the case if banks had been recapitalized aggressively early on in the recession, as was done in the USA. This may well explain why the US has recovered so much faster than Europe from the financial crisis induced recession.