The macroeconomics of banking

This thesis studies the macroeconomic effectiveness of monetary and fiscal policy in an environment where commercial banks are undercapitalized after a financial crisis and have large holdings of (risky) government bonds on their balance sheets. An undercapitalized banking system cannot perfectly elastically expand the balance sheet, and therefore has to choose whether an additional euro of funding is used to provide new credit to the real economy or purchase additional government bonds.
The main result of this thesis is that the effectiveness of monetary and fiscal policy is reduced in such an environment. Two channels play a key role.
The first is one where capital losses arise on existing holdings of risky government bonds held by commercial banks when the fiscal authority engages in debt-financed fiscal policy. More debt issue increases interest rates and lowers bond prices because of increased sovereign default risk. The ensuing capital losses reduce bank capital (bank equity) and therefore force commercial banks to shrink the balance sheet, with negative effects on financing investment in the real economy. This channel is at work in chapters one and two.
The second channel is at work in chapters three and four, where a change in government policy increases the attractiveness for commercial banks to hold government bonds. Because of limited balance sheet capacity after a financial crisis, commercial banks increase government bond holdings at the expense of loan provision to the real economy, which negatively affects the macroeconomy through lower investment.