Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans

Max Bruche and Gerard Llobet

FMG Discussion Papers from Financial Markets Group

Abstract: Because of limited liability, insolvent banks have an incentive to roll over bad loans, in order to hide losses and gamble for resurrection, even though this is socially inefficient. We suggest a scheme that regulators could use to solve this problem. The scheme would induce banks to reveal their bad loans, which can then be foreclosed. Bank participation in the scheme would be voluntary. Even though banks have private information on the quantity of bad loans on their balance sheet, the scheme avoids creating windfall gains for bank equity holders. In addition, some losses can be imposed on debt holders.

Date: 2011-03
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Working Paper: Walking wounded or living dead? Making banks foreclose bad loans (2011)
Working Paper: Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans (2010)
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