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Cash-in-the-Market Pricing and Optimal Bank Bailout Policy

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Author Info
Acharya, Viral V
Yorulmazer, Tanju

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Abstract

As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in ‘cash-in-the-market’ pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex post optimal for the regulator to bail out some failed banks. Ex ante, this gives banks an incentive to herd by investing in correlated assets, thereby making aggregate banking crises more likely. These effects are robust to allowing the surviving banks to issue equity and allowing the regulator to price-discriminate against outsiders in the market for bank sales.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5154.

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Date of creation: Jul 2005
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Handle: RePEc:cpr:ceprdp:5154

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Related research
Keywords: bank regulation; banking crises; herding; systemic risk; time inconsistency; too many to fail;

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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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  2. Williamson, Oliver E, 1988. " Corporate Finance and Corporate Governance," Journal of Finance, American Finance Association, vol. 43(3), pages 567-91, July. [Downloadable!] (restricted)
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  5. 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. [Downloadable!] (restricted)
  6. Acharya, Viral V & Yorulmazer, Tanju, 2004. "Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies," CEPR Discussion Papers 4778, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  7. Perotti, Enrico C. & Suarez, Javier, 2002. "Last bank standing: What do I gain if you fail?," European Economic Review, Elsevier, vol. 46(9), pages 1599-1622, October. [Downloadable!] (restricted)
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  12. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September. [Downloadable!] (restricted)
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  14. Honohan, Patrick & Klingebiel, Daniela, 2000. "Controlling the fiscal costs of banking crises," Policy Research Working Paper Series 2441, The World Bank. [Downloadable!]
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  17. 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. [Downloadable!] (restricted)
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    Other versions:
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