Bank capital, the state contingency of banks' assets and its role for the transmission of shocks

I show how the evolution of bank capital depends on the share of non-state-contingent assets in banks' balance sheets and present the implications for macroeconomic dynamics. State-contingent securities impact on banks' balance sheets through changes in their returns (and their prices), both of which depend on the current state of the economy. Non-state-contingent assets are signed before shocks are realized and their repayment is guaranteed. For this reason, they insulate banks' balance sheets from recent economic activity in the absence of defaults. Non-state-contingent assets in banks' balance sheets attenuate the amplification of shocks resulting from financial frictions. The same effect can be achieved if more weight is placed on the state-contingent assets in the equity related constraint against the costs of long-run output losses.