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An Analysis of Closure Policy under Alternative Regulatory Structures

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  • Greg Caldwell
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    Abstract

    The author develops a theoretical model of bank closure. The regulatory decision about bank failure consists of two parts: whether to close and how to close. Assuming that the closure decision is credible, the welfare implications of two resolution regimes are considered. In one case, a meta-regulator supervises, closes, and resolves failed banks using an ex post efficient criterion. In the other case, a supervisor closes the bank while a deposit insurer resolves the closure on the basis of least cost. The bank chooses the riskiness of its loan portfolio in response to the announced policy. The supervisor can limit risk-shifting incentives of banks ex ante by raising capital requirements. The cost of this decision is a misallocation of economic resources, since some welfare-enhancing projects are abandoned. Market discipline is determined both exogenously, by the level of uninsured depositors, and endogeneously, by the regime and capital requirements chosen. Least costly resolution weakly dominates an ex post efficient resolution decision when market discipline is present. Neither mechanism outperforms when it is reliant on capital regulation in the absence of market discipline.

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    Bibliographic Info

    Paper provided by Bank of Canada in its series Working Papers with number 05-11.

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    Length: 38 pages
    Date of creation: 2005
    Date of revision:
    Handle: RePEc:bca:bocawp:05-11

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    Keywords: Financial Institutions;

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    1. G. G. Garcia, 1999. "Deposit Insurance," IMF Working Papers 99/54, International Monetary Fund.
    2. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    3. George J. Mailath & Loretta J. Mester, 1993. "A positive analysis of bank closure," Working Papers 94-2, Federal Reserve Bank of Philadelphia.
    4. By Charles Enoch & Gillian Garcia & V. Sundararajan, 2001. "Recapitalizing Banks with Public Funds," IMF Staff Papers, Palgrave Macmillan, vol. 48(1), pages 3.
    5. Charles M. Kahn & João A. C. Santos, 2001. "Allocating bank regulatory powers: lender of last resort, deposit insurance and supervision," BIS Working Papers 102, Bank for International Settlements.
    6. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    7. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
    8. Glenn Hoggarth & Jack Reidhill & Peter Sinclair, 2004. "On the resolution of banking crises: theory and evidence," Bank of England working papers 229, Bank of England.
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