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Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies

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  • Acharya, Viral V
  • Yorulmazer, Tanju

Abstract

This Paper shows that bank closure policies suffer from a ‘too-many-to-fail’ problem: when the number of bank failures is large, the regulator finds it ex-post optimal to bail out some or all failed banks, whereas when the number of bank failures is small, failed banks can be acquired by the surviving banks. This gives banks incentives to herd and increases systemic risk, the risk that many banks may fail together. The ex-post optimal regulation may thus be sub-optimal from an ex-ante standpoint. We formalize this time-inconsistency of bank regulation. We also argue that by allowing banks to purchase failed banks at discounted prices and by partially nationalizing the bailed-out banks, a regulator may be able to mitigate the induced systemic risk.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4778.

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Date of creation: Dec 2004
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Handle: RePEc:cpr:ceprdp:4778

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Keywords: bailout; bank regulation; herding; moral hazard; systemic risk;

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
  2. Asli Demirgüç-Kunt & Enrica Detragiache, 2000. "Does Deposit Insurance Increase Banking System Stability?," IMF Working Papers 00/3, International Monetary Fund.
  3. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
  4. Valev, N, 1996. "International Lending by US Banks," Papers 96-010, Purdue University, Krannert School of Management - Center for International Business Education and Research (CIBER).
  5. Hoggarth, Glenn & Jackson, Patricia & Nier, Erlend, 2005. "Banking crises and the design of safety nets," Journal of Banking & Finance, Elsevier, vol. 29(1), pages 143-159, January.
  6. 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.
  7. Rajan, Raghuram G, 1994. "Why Bank Credit Policies Fluctuate: A Theory and Some Evidence," The Quarterly Journal of Economics, MIT Press, vol. 109(2), pages 399-441, May.
  8. Jeremy C. Stein & David S. Scharfstein, 2000. "Herd Behavior and Investment: Reply," American Economic Review, American Economic Association, vol. 90(3), pages 705-706, June.
  9. Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
  10. Craig O. Brown & I. Serdar Dinç, 2005. "The Politics of Bank Failures: Evidence from Emerging Markets," The Quarterly Journal of Economics, MIT Press, vol. 120(4), pages 1413-1444, November.
  11. Boot, Arnoud W A & Thakor, Anjan V, 1993. "Self-Interested Bank Regulation," American Economic Review, American Economic Association, vol. 83(2), pages 206-12, May.
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