Resolving Banking Crises - an Analysis of Policy Options

42 Pages Posted: 5 Apr 2006

Date Written: March 2006

Abstract

This paper develops a dynamic model to examine the ex-ante and ex-post implications of five policy options for resolving bank failures when the authorities cannot observe the level of non-performing loans (NPLs) held by individual banks. Under asymmetric information, we show that the first-best outcome is achievable when the authorities can close all banks that fail to raise a minimum level of new capital. But when the authorities cannot close banks and must rely on financial incentives to induce banks to liquidate their NPLs, recapitalisation using equity (Tier 1 capital) would be the second-best policy, whereas recapitalisation using subordinated debt (Tier 2 capital) is suboptimal. If the authorities do not wish to hold an equity stake in a bank, they should subsidise the liquidation of non-performing loans rather than inject subordinated debt. We also show that the cost of this subsidy can be reduced if it is offered in a menu that includes equity injection.

JEL Classification: G21, G28

Suggested Citation

Tanaka, Misa and Hoggarth, Glenn, Resolving Banking Crises - an Analysis of Policy Options (March 2006). Bank of England Working Paper No. 293, Available at SSRN: https://ssrn.com/abstract=894883 or http://dx.doi.org/10.2139/ssrn.894883

Misa Tanaka (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Glenn Hoggarth

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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