Moral hazard under the Japanese "convoy" banking system

This paper examines a banking regime similar to the "convoy" scheme which prevailed in Japan through most of the 1990s. Insolvent banks are merged with solvent banks rather than closed, with the acquiring banks required to accept negative value banks at zero value. I demonstrate that a convoy scheme effectively taxes the acquiring bank and increases moral hazard by reducing bank effort towards enhancing its portfolio, even relative to a fixed-premium deposit insurance system, for negative value banks. However, for positive bank charter values, which are retained under the convoy scheme and lost under the deposit insurance program, these effects may be mitigated or even overturned. I also find that the rules governing the convoy scheme can affect bank behavior. I compare two convoy regimes, one where acquiring banks are chosen at random and one where the weakest banks are paired with the strongest banks. Simulations reveal that the disparities in bank effort between the two convoy regimes are greater than those between the convoy regimes and the fixed-premium deposit insurance regime. I confirm the theoretical result above that the bank effort under either convoy program is increasing in bank charter value.