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Forbearance and Prompt Corrective Action

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  • Narayana Kocherlakota
  • Ilhyock Shim

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 UCLA Department of Economics in its series Levine's Bibliography with number 666156000000000532.

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Date of creation: 25 Feb 2005
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Handle: RePEc:cla:levrem:666156000000000532

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  1. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Christopher Sleet & Bruce D. Smith, 2000. "Deposit insurance and lender-of-last-resort functions," Proceedings, Federal Reserve Bank of Cleveland, pages 518-579.
  3. Dekle, Robert & Kletzer, Kenneth, 2003. "The Japanese banking crisis and economic growth: Theoretical and empirical implications of deposit guarantees and weak financial regulation," Journal of the Japanese and International Economies, Elsevier, vol. 17(3), pages 305-335, September.
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Cited by:
  1. Ilhyock Shim, 2006. "Dynamic prudential regulation: Is prompt corrective action optimal?," BIS Working Papers 206, Bank for International Settlements.
  2. David VanHoose, 2007. "Market Discipline and Supervisory Discretion in Banking: Reinforcing or Conflicting Pillars of Basel II?," NFI Working Papers 2007-WP-06, Indiana State University, Scott College of Business, Networks Financial Institute.
  3. Vollmer, Uwe & Wiese, Harald, 2013. "Minimum capital requirements, bank supervision and special resolution schemes. Consequences for bank risk-taking," Journal of Financial Stability, Elsevier, vol. 9(4), pages 487-497.
  4. Narayana Kocherlakota & Cristina Arellano, 2008. "Internal Debt Crises and Sovereign Defaults," 2008 Meeting Papers 139, Society for Economic Dynamics.
  5. Robert E. Hall, 2008. "Equity Depletion from Government-Guaranteed Debt," NBER Working Papers 14581, National Bureau of Economic Research, Inc.
  6. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers 229, Bank for International Settlements.
  7. Eijffinger, Sylvester C W & Nijskens, Rob, 2011. "Complementing Bagehot: Illiquidity and insolvency resolution," CEPR Discussion Papers 8603, C.E.P.R. Discussion Papers.
  8. Xavier Freixas & Bruno Maria Parigi, 2007. "Banking Regulation and Prompt Corrective Action," CESifo Working Paper Series 2136, CESifo Group Munich.

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