Interest-Rate Policy and Stability of Banking Systems

We investigate a banking system subject to repeated macroeconomic productivity shocks. By lowering the interest rates, the central bank can increase the intermediation margin, which fosters the recapitalization of banks. We show that without lowering interest rates, the banking system faces the risk of collapsing. When interest policy is aimed only at avoiding a banking collapse, the economy converges with certainty to a consumption trap. In the consumption trap, the entire bank savings are needed to cover the banks’ obligations and GDP is minimal. We present a positive analysis of conditions for interest-rate policies which resolve banking crises. Moreover, we provide an explanation of why banking crises such as the crisis in Japan may cause long-lasting economic downturns.