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Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies

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  • Acharya, Viral
  • Yorulmazer, Tanju

Abstract

This Paper shows that bank closure policies suffer from a ?too-many-to-fail? problem: when the number of bank failures is large, the regulator finds it ex-post optimal to bail out some or all failed banks, whereas when the number of bank failures is small, failed banks can be acquired by the surviving banks. This gives banks incentives to herd and increases systemic risk, the risk that many banks may fail together. The ex-post optimal regulation may thus be sub-optimal from an ex-ante standpoint. We formalize this time-inconsistency of bank regulation. We also argue that by allowing banks to purchase failed banks at discounted prices and by partially nationalizing the bailed-out banks, a regulator may be able to mitigate the induced systemic risk.

Suggested Citation

  • Acharya, Viral & Yorulmazer, Tanju, 2004. "Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies," CEPR Discussion Papers 4778, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:4778
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    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • 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
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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