Working Paper: CEPR ID: DP4778
Authors: Viral V. Acharya; Tanju Yorulmazer
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.
Keywords: bailout; bank regulation; herding; moral hazard; systemic risk
JEL Codes: D62; E58; G21; G28; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regulator's ex post optimal decision to bail out banks when many are failing (G28) | Time inconsistency problem (D15) |
| Time inconsistency problem (D15) | Encouragement of banks to herd (G21) |
| Encouragement of banks to herd (G21) | Increase in systemic risk (F65) |
| Regulator's inability to commit to a consistent policy (E61) | Incentives for banks to engage in correlated investments (G21) |
| Incentives for banks to engage in correlated investments (G21) | Heightened risk of systemic crises (F65) |
| Banks purchasing failed banks at discounted prices (G21) | Mitigation of systemic risk induced by bailout policies (G28) |