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Economic Quarterly

Fall 2001

Should Banks Be Recapitalized?

Douglas W. Diamond

When a bank is a relationship lender, its financial health affects its borrowers’ access to credit. If regulators or depositors might close a bank, it will take any action necessary to remain open. This leads to excessive foreclosure of the bank’s relationship-based loans or to the bank’s inability to collect existing loans due to its fear of accounting losses if it forecloses. Recapitalization of banks possessing relationship-based loans can be good policy. However, providing a positive but too small amount of capital can be worse than providing none. There is no reason to provide subsidized capital to banks without relationship-based loans.

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