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Forbearance and prompt corrective action

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  • Ilhyock Shim
  • Narayana Kocherlakota

    (University of Minnesota - Twin Cities - Department of Economics)

Abstract

This paper investigates whether a bank regulator should terminate problem banks promptly or exercise forbearance. We construct a dynamic model economy in which entrepreneurs pledge collateral, borrow from banks, and invest in long-term projects. We assume that collateral value has aggregate risk over time, that in any period entrepreneurs can abscond with the projects but losing the collateral, and that depositors can withdraw deposits. We show that optimal regulation exhibits forbearance if the ex-ante probability of collapse in collateral value is sufficiently low, but exhibits prompt termination of problem banks if this probability is sufficiently high.

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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 177.

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Length: 27 pages
Date of creation: May 2005
Date of revision:
Handle: RePEc:bis:biswps:177

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Keywords: risky collateral; limited enforcement; banking regulation; optimal social contract;

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References

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  1. Christopher Sleet & Bruce D. Smith, 2000. "Deposit insurance and lender-of-last-resort functions," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 518-579.
  2. Robert Dekle & Kenneth Kletzer, 2003. "The Japanese Banking Crisis and Economic Growth: Theoretical and Empirical Implications of Deposit Guarantees and Weak Financial Regulation," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-225, CIRJE, Faculty of Economics, University of Tokyo.
  3. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 106(1), pages 1-40, February.
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Citations

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Cited by:
  1. Xavier Freixas & Bruno Maria Parigi, 2007. "Banking Regulation and Prompt Corrective Action," CESifo Working Paper Series, CESifo Group Munich 2136, CESifo Group Munich.
  2. Cristina Arellano & Narayana R. Kocherlakota, 2008. "Internal Debt Crises and Sovereign Defaults," NBER Working Papers 13794, National Bureau of Economic Research, Inc.
  3. Eijffinger, Sylvester C W & Nijskens, Rob, 2011. "Complementing Bagehot: Illiquidity and insolvency resolution," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8603, C.E.P.R. Discussion Papers.
  4. David VanHoose, 2007. "Market Discipline and Supervisory Discretion in Banking: Reinforcing or Conflicting Pillars of Basel II?," NFI Working Papers, Indiana State University, Scott College of Business, Networks Financial Institute 2007-WP-06, Indiana State University, Scott College of Business, Networks Financial Institute.
  5. Vollmer, Uwe & Wiese, Harald, 2013. "Minimum capital requirements, bank supervision and special resolution schemes. Consequences for bank risk-taking," Journal of Financial Stability, Elsevier, Elsevier, vol. 9(4), pages 487-497.
  6. Robert E. Hall, 2008. "Equity Depletion from Government-Guaranteed Debt," NBER Working Papers 14581, National Bureau of Economic Research, Inc.
  7. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers, Bank for International Settlements 229, Bank for International Settlements.
  8. Ilhyock Shim, 2006. "Dynamic prudential regulation: Is prompt corrective action optimal?," BIS Working Papers, Bank for International Settlements 206, Bank for International Settlements.

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