Bank capital, firm liquidity, and project quality

We construct an economy where a two way interaction between bank capital and project quality propagates negative shocks to technology or regulation. By shrinking the available liquidity and the scale of their activity, a contraction in bank loans discourages entrepreneurs from sustaining the setup effort of high quality projects, inducing them to shift to low quality ones. The deterioration in project quality erodes the value of bank assets and, hence, banks' capitalization and loanable funds. Lack of information in the secondary market for bank assets amplifies the propagation. (c) 2007 Elsevier B.V. All rights reserved.