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Aggregate Shock, Capital Market Opening, and Optimal Bailout

Author

Listed:
  • Se-Jik Kim

    (KIEP - Korea Institute for International Economic Policy)

  • Ivailo Izvorski

Abstract

This paper explores the joint effect of aggregate productivity shocks and capital market liberalization on the optimal bailout (or liquidation) policy of banks towards defaulted borrowers. It suggests that in bad times both good and bad firms default on their obligations, it is harder for the bank to distinguish between the two and therefore it is less costly to bail out defaulted firms. Therefore, the optimal liquidation rate in a closed economy may be substantially lower in recessions than in booms. In an economy with open capital markets, however, the corporate rate of return has to be raised at least up to the world rate of interest by improving the composition of the corporate sector through higher liquidation in order to prevent an outflow of capital and the subsequent financial crisis. As a result, the optimal liquidation rate (bailout rate) during recessions may be much higher (lower) in an economy with liberalized capital markets than in a closed economy. The model in this paper explains why liquidation rates of defaulted firms have risen significantly and structural reform to facilitate more liquidation has been purchased after the financial crisis in those East Asian countries with more liberalized capital markets.

Suggested Citation

  • Se-Jik Kim & Ivailo Izvorski, 2001. "Aggregate Shock, Capital Market Opening, and Optimal Bailout," Finance Working Papers 21764, East Asian Bureau of Economic Research.
  • Handle: RePEc:eab:financ:21764
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    File URL: http://www.eaber.org/node/21764
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    More about this item

    Keywords

    capital market opening; optimal bailout; aggregate productivity shocks;

    JEL classification:

    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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