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Forbearance and Prompt Corrective Action

  • NARAYANA R. KOCHERLAKOTA
  • ILHYOCK SHIM

This article investigates whether a bank regulator should terminate problem banks promptly or exercise forbearance. We construct a dynamic model economy in which entrepreneurs pledge collateral, borrow from banks, and invest in long-term projects. We assume that collateral value has aggregate risk over time, that in any period entrepreneurs can abscond with the projects but lose the collateral, and that depositors can withdraw deposits. We show that optimal regulation exhibits forbearance if the ex-ante probability of collapse in collateral value is sufficiently low, but exhibits prompt termination of problem banks if this probability is sufficiently high. Copyright 2007 The Ohio State University.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1538-4616.2007.00059.x
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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 39 (2007)
Issue (Month): 5 (08)
Pages: 1107-1129

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Handle: RePEc:mcb:jmoncb:v:39:y:2007:i:5:p:1107-1129
Contact details of provider: Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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  1. Christopher Sleet & Bruce D. Smith, 2000. "Deposit insurance and lender-of-last-resort functions," Proceedings, Federal Reserve Bank of Cleveland, pages 518-579.
  2. Robert Dekle & Kenneth Kletzer, 2003. "The Japanese Banking Crisis and Economic Growth: Theoretical and Empirical Implications of Deposit Guarantees and Weak Financial Regulation," CIRJE F-Series CIRJE-F-225, CIRJE, Faculty of Economics, University of Tokyo.
  3. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
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