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Discussion Paper Details

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

Author(s): Viral V. Acharya and Tanju Yorulmazer

Publication Date: December 2004

Keyword(s): bailout, bank regulation, herding, moral hazard and systemic risk

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Acharya, V and Yorulmazer, T. 2004. 'Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4778