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An Analysis of Closure Policy under Alternative Regulatory Structures


  • Greg Caldwell


The author develops a theoretical model of bank closure. The regulatory decision about bank failure consists of two parts: whether to close and how to close. Assuming that the closure decision is credible, the welfare implications of two resolution regimes are considered. In one case, a meta-regulator supervises, closes, and resolves failed banks using an ex post efficient criterion. In the other case, a supervisor closes the bank while a deposit insurer resolves the closure on the basis of least cost. The bank chooses the riskiness of its loan portfolio in response to the announced policy. The supervisor can limit risk-shifting incentives of banks ex ante by raising capital requirements. The cost of this decision is a misallocation of economic resources, since some welfare-enhancing projects are abandoned. Market discipline is determined both exogenously, by the level of uninsured depositors, and endogeneously, by the regime and capital requirements chosen. Least costly resolution weakly dominates an ex post efficient resolution decision when market discipline is present. Neither mechanism outperforms when it is reliant on capital regulation in the absence of market discipline.

Suggested Citation

  • Greg Caldwell, 2005. "An Analysis of Closure Policy under Alternative Regulatory Structures," Staff Working Papers 05-11, Bank of Canada.
  • Handle: RePEc:bca:bocawp:05-11

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    References listed on IDEAS

    1. Mailath George J. & Mester Loretta J., 1994. "A Positive Analysis of Bank Closure," Journal of Financial Intermediation, Elsevier, vol. 3(3), pages 272-299, June.
    2. Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision," European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.
    3. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    4. Glenn Hoggarth & Jack Reidhill & Peter Sinclair, 2004. "On the resolution of banking crises: theory and evidence," Bank of England working papers 229, Bank of England.
    5. By Charles Enoch & Gillian Garcia & V. Sundararajan, 2001. "Recapitalizing Banks with Public Funds," IMF Staff Papers, Palgrave Macmillan, vol. 48(1), pages 1-3.
    6. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    7. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-438, July.
    8. G. G. Garcia, 1999. "Deposit Insurance; A Survey of Actual and Best Practices," IMF Working Papers 99/54, International Monetary Fund.
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    More about this item


    Financial Institutions;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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