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

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Author Info
Acharya, Viral V
Yorulmazer, Tanju

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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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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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Related research
Keywords: bailout bank regulation herding moral hazard systemic risk

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Find related papers by JEL classification:
D62 - Microeconomics - - Welfare Economics - - - Externalities
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Barron, John M & Valev, Neven T, 2000. "International Lending by U.S. Banks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 357-81, August.
  2. 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. [Downloadable!] (restricted)
  3. David S. Scharfstein & Jeremy C. Stein, 2000. "Herd Behavior and Investment: Reply," American Economic Review, American Economic Association, vol. 90(3), pages 705-706, June. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Viral Acharya & Tanju Yorulmazer, . "Cash-in-the-market pricing and optimal resolution of bank failures," Bank of England working papers 328, Bank of England. [Downloadable!]
  2. Acharya, Viral V & Yorulmazer, Tanju, 2005. "Cash-in-the-Market Pricing and Optimal Bank Bailout Policy," CEPR Discussion Papers 5154, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  3. Wagner, Wolf, 2006. "Diversification at financial institutions and systemic crises," Discussion Paper 71, Tilburg University, Center for Economic Research. [Downloadable!]
  4. Huberto M. Ennis & Todd Keister, 2007. "Commitment and equilibrium bank runs," Staff Reports 274, Federal Reserve Bank of New York. [Downloadable!]
  5. Wagner, Wolf, 2006. "The broadening of activities in the financial system : implications for financial stability and regulation," Discussion Paper 72, Tilburg University, Center for Economic Research. [Downloadable!]
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