Abstract: When default losses elevate borrowing costs, expanding credit cannot stabilize the economy because default rates feed back to lending rates through bank balance sheets. Asset management companies (AMCs) break this loop by purchasing nonperforming loans at their long-run recovery values, thereby fixing the effective default rate that banks face. Government purchases of performing loans expand credit but leave this feedback intact. In a model calibrated to the eurozone, the AMC reduces quarterly default rates by 0.8 percentage points, lowers lending rates by 1.6 percentage points, and raises welfare by 0.2%. Government purchases crowd out bank deposits, contracting credit; default rates rise by 1.8 percentage points, lending rates increase by 1.2 percentage points, and welfare falls by 0.3%.
https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp3195~4c8f3c8786.en.pdf
