Slow Recoveries, Endogenous Growth and Macro-prudential Policy

Banking crises have severe short and long-term consequences. We develop a general equilibrium model with financial frictions and endogenous growth in which macro-prudential policy supports economic activity and productivity growth by strengthening bank’s resilience to adverse financial shocks. The improved intermediation capacity of a safer banking system leads to a higher steady state growth rate. The optimal bank capital ratio of 18% increases welfare by 6.7%, 14 times more than in the case without endogenous growth. When the economy enters a liquidity trap, the effects of financial disruptions and thus the benefits of macro-prudential policy are even more significant.