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Aggregate Shock, Capital Market Opening, and Optimal Bailout

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  • Se-Jik Kim

    (KIEP - Korea Institute for International Economic Policy)

  • Ivailo Izvorski
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    Abstract

    This paper explores the joint effect of aggregate productivity shocks and capital market liberalization on the optimal bailout (or liquidation) policy of banks towards defaulted borrowers. It suggests that in bad times both good and bad firms default on their obligations, it is harder for the bank to distinguish between the two and therefore it is less costly to bail out defaulted firms. Therefore, the optimal liquidation rate in a closed economy may be substantially lower in recessions than in booms. In an economy with open capital markets, however, the corporate rate of return has to be raised at least up to the world rate of interest by improving the composition of the corporate sector through higher liquidation in order to prevent an outflow of capital and the subsequent financial crisis. As a result, the optimal liquidation rate (bailout rate) during recessions may be much higher (lower) in an economy with liberalized capital markets than in a closed economy. The model in this paper explains why liquidation rates of defaulted firms have risen significantly and structural reform to facilitate more liquidation has been purchased after the financial crisis in those East Asian countries with more liberalized capital markets.

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    Bibliographic Info

    Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 21764.

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    Date of creation: Sep 2001
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    Handle: RePEc:eab:financ:21764

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    Related research

    Keywords: capital market opening; optimal bailout; aggregate productivity shocks;

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