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A theory of failed bank resolution: Technological change and political economics

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  • DeYoung, Robert
  • Kowalik, Michal
  • Reidhill, Jack
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    Abstract

    We model the failed bank resolution process as a repeated game between a utility-maximizing government resolution authority (RA) and a profit-maximizing banking industry. Limits to resolution technology and political/economic pressure create incentives for the RA to bail out failed complex banks; the inability of the RA to credibly commit to closing these banks creates an incentive for bank complexity. We solve the game in mixed strategies and find equilibrium conditions remarkably descriptive of government responses to actual and potential large bank insolvencies during the recent financial crisis. The central role of the technology constraint in this model highlights a crucial determinant of failed bank resolution policy that has been overlooked in the theory literature to date; without improved resolution technologies, future bank bailouts are inevitable. The effects of political pressure in this model remind us that regulatory reform (e.g., Dodd-Frank) is only as good as the regulators that implement the reform.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Stability.

    Volume (Year): 9 (2013)
    Issue (Month): 4 ()
    Pages: 612-627

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    Handle: RePEc:eee:finsta:v:9:y:2013:i:4:p:612-627

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    Web page: http://www.elsevier.com/locate/jfstabil

    Related research

    Keywords: Bank failures; Failed bank resolution; Bankruptcy; FDIC;

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    References

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    Cited by:
    1. Korte, Josef, 2013. "Catharsis - The Real Effects of Bank Insolvency and Resolution," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79938, Verein für Socialpolitik / German Economic Association.
    2. Korte, Josef, 2013. "Catharsis - The real effects of bank insolvency and resolution," Discussion Papers 21/2013, Deutsche Bundesbank, Research Centre.

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