Resolving banking crises - an analysis of policy options
AbstractThis paper develops a dynamic model to examine the ex-ante and ex-post implications of five policy options for resolving bank failures when the authorities cannot observe the level of non-performing loans (NPLs) held by individual banks. Under asymmetric information, we show that the first-best outcome is achievable when the authorities can close all banks that fail to raise a minimum level of new capital. But when the authorities cannot close banks and must rely on financial incentives to induce banks to liquidate their NPLs, recapitalisation using equity (Tier 1 capital) would be the second-best policy, whereas recapitalisation using subordinated debt (Tier 2 capital) is suboptimal. If the authorities do not wish to hold an equity stake in a bank, they should subsidise the liquidation of non-performing loans rather than inject subordinated debt. We also show that the cost of this subsidy can be reduced if it is offered in a menu that includes equity injection.
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Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 293.
Date of creation: Mar 2006
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-09-30 (All new papers)
- NEP-BAN-2006-09-30 (Banking)
- NEP-CBA-2006-09-30 (Central Banking)
- NEP-FMK-2006-09-30 (Financial Markets)
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