Working Paper: CEPR ID: DP9612
Authors: Joel Shapiro; David Skeie
Abstract: A regulator resolving a bank faces two audiences: depositors, who may run if they believe the regulator will not provide capital, and banks, which may take excess risk if they believe the regulator will provide capital. When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (i) A regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (ii) A regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs. Regulators perform more informative stress tests when the market is pessimistic.
Keywords: bank regulation; financial crisis; reputation; sovereign debt crisis; stress tests
JEL Codes: G01; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regulator's actions (G18) | Depositors' beliefs (G21) |
| Regulator's actions (G18) | Banks' risk-taking behavior (G21) |
| Regulator's actions signal its type (L51) | Market's reactions (G10) |
| Regulator's cost of injecting capital (G18) | Regulator's decisions (G18) |
| Regulator's decisions (G18) | Different equilibria in the banking system (D53) |
| Regulator's forbearance on bad banks (G28) | Future risk-taking by banks (G21) |
| Regulator's reputation of low costs of capital injections (G28) | Depositors' beliefs (G21) |