Working Paper: CEPR ID: DP1977
Authors: Janet Mitchell
Abstract: Many countries, including economies in transition, have suffered banking crises in recent years. This paper develops a general framework for analysing trade-offs between policies for cleaning banks' balance sheets of bad debt. The framework - a two-tier hierarchy consisting of regulators, banks, and firms - is applied to analyse three types of policies that have been advocated or employed in the economies in transition. Hidden information and moral hazard are present at each tier of the hierarchy. The analysis identifies two types of effects of policy choice: a direct effect of the policy on bank behaviour and an indirect effect on firm behaviour as a reaction to the bank response. Both effects are important determinants of policy trade-offs. The analysis demonstrates that differing policies applied to financially distressed banks have differing real effects on firms' and banks' asset values, even when all firms and banks are state-owned.
Keywords: banking crises; bad debts; economies in transition; creditor passivity
JEL Codes: G21; G38; P5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Differing policies for cleaning banks' balance sheets (G28) | Differing real effects on banks' and firms' asset values (E44) |
| Regulatory policy (G18) | Bank behavior (G21) |
| Bank behavior (G21) | Borrower behavior (G51) |
| Banks' choices between rolling over and working out bad loans (G21) | Firm asset dissipation levels (G33) |
| Banks choosing to roll over loans in default (G21) | Higher levels of asset dissipation by firm managers (G32) |
| Debt cancellation (F34) | Reduce asset dissipation levels (G33) |
| Debt cancellation eliminates the workout mechanism that allows for information gathering about firms' values (G33) | Effectiveness of a bad debt bank in slowing asset dissipation during workouts (G33) |
| Effectiveness of a bad debt bank in slowing asset dissipation during workouts (G33) | Determining the optimal policy (C61) |