Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans

Due to limited liability, banks that are essentially insolvent may have incentives to roll over bad loans as a gamble for resurrection, even though it is socially inefficient to do so. This paper considers the problem of making such banks remove and/or foreclose bad loans, when the proportion of loans on a bank’s balance sheet that has gone bad is private information. The private information implies that many plausible schemes are likely to generate windfall gains for bank equity holders, which is undesirable. We propose a scheme with voluntary participation, under which banks (i) reveal the proportion of bad loans on their balance sheet, (ii) remove or foreclose them, and (iii) bank equity holders are no better off than they would be in the absence of the scheme, that is, the scheme produces no windfall gains for bank equity holders.