This paper investigates how business cycle volatility affects internal and external funding sources of banks. It argues that excessive credit growth, credit cycles, and bank failures are phenomena related to distinct patterns of banks' financing options over the cycle. This perspective reconciles rational behavior with some implications of Minsky's financial instability hypothesis.
We analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allow banks to influence the scale of assistance and externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives, but may have higher fiscal costs.
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