Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies

Viral Acharya and Tanju Yorulmazer

No 4778, CEPR Discussion Papers from Centre for Economic Policy Research

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: Bank regulation; Systemic risk; Bailout; Moral hazard; Herding (search for similar items in EconPapers)
JEL-codes: D62 E58 G21 G28 G38 (search for similar items in EconPapers)
Date: 2004-12
New Economics Papers: this item is included in nep-fin and nep-mac
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Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Too many to fail--An analysis of time-inconsistency in bank closure policies (2007)
Working Paper: Too many to fail - an analysis of time-inconsistency in bank closure policies (2007)
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