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Walking Wounded Or Living Dead? Making Banks Foreclose Bad Loans

  • Max Bruche

    ()

    (CEMFI, Centro de Estudios Monetarios y Financieros)

  • Gerard Llobet

    ()

    (CEMFI, Centro de Estudios Monetarios y Financieros)

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 widfall 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.

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File URL: http://www.cemfi.es/ftp/wp/1003.pdf
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Paper provided by CEMFI in its series Working Papers with number wp2010_1003.

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Date of creation: Mar 2010
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Handle: RePEc:cmf:wpaper:wp2010_1003
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  1. Sudipto Bhattacharya & Kjell G. Nyborg, 2011. "Bank Bailout Menus," FMG Discussion Papers dp676, Financial Markets Group.
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  4. Jenny Corbett & Janet Mitchell, 2000. "Banking Crises and Bank Rescues: The Effect of Reputation," William Davidson Institute Working Papers Series 290, William Davidson Institute at the University of Michigan.
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  9. Christopher L. House & Yusufcan Masatlioglu, 2010. "Managing Markets for Toxic Assets," NBER Working Papers 16145, National Bureau of Economic Research, Inc.
  10. Sekine, Toshitaka & Kobayashi, Keiichiro & Saita, Yumi, 2003. "Forbearance Lending: The Case of Japanese Firms," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 21(2), pages 69-92, August.
  11. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, June.
  12. Englund, Peter, 1999. "The Swedish Banking Crisis: Roots and Consequences," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 80-97, Autumn.
  13. Lawrence M. Ausubel & Peter Cramton, 2008. "A Troubled Asset Reverse Auction," Papers of Peter Cramton 08tara, University of Maryland, Department of Economics - Peter Cramton, revised 2008.
  14. Philippe Aghion, Patrick Bolton & Steven Fries, 1999. "Optimal Design of Bank Bailouts: The Case of Transition Economies," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 155(1), pages 51-, March.
  15. Sudheer Chava & Michael R. Roberts, 2008. "How Does Financing Impact Investment? The Role of Debt Covenants," Journal of Finance, American Finance Association, vol. 63(5), pages 2085-2121, October.
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