Working Paper: CEPR ID: DP16680
Authors: Jeremy Bulow; Paul Klemperer
Abstract: Banks' reluctance to repair their balance sheets, combined with deposit insurance and regulatory forbearance in recognizing greater risks and losses, can lead to solvency problems that look like liquidity (bank-run) crises. Regulatory forbearance incentivizes banks to both retain risky loans and reject new good opportunities. With sufficient regulatory forbearance, partially-insured banks act exactly as if they are fully insured. Stress tests certify that uninsured creditors will be paid, not that banks are solvent, and have ambiguous effects on the efficiency of investment.
Keywords: bank capital; regulatory capital; capital requirements; regulatory forbearance; bank runs; solvency runs; liquidity runs; stress tests; financial crisis
JEL Codes: G10; G21; G28; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory forbearance (G28) | banks retain risky loans (G21) |
| regulatory forbearance (G28) | banks reject new lending opportunities (G21) |
| banks' reluctance to repair balance sheets + deposit insurance + regulatory forbearance (G28) | solvency issues resembling liquidity crises (G33) |
| regulatory forbearance (G28) | banks behave as if fully insured (G28) |
| regulatory forbearance (G28) | retention of toxic assets (G32) |
| regulatory forbearance (G28) | rejection of profitable new loans (G21) |