DP13617 Bank Capital Forbearance

Author(s): Natalya Martynova, Enrico C Perotti, Javier Suarez
Publication Date: March 2019
Keyword(s): Bank Recapitalization, bank supervision, Forbearance
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13617

We analyze the strategic interaction between undercapitalized banks and a supervisor who may intervene by preventive recapitalization. Supervisory forbearance emerges because of a commitment problem, reinforced by fiscal costs and constrained capacity. Private incentives to comply are lower when supervisors have lower credibility, especially for highly levered banks. Less credible supervisors (facing higher cost of intervention) end up intervening more banks, yet producing higher forbearance and systemic costs of bank distress. Importantly, when public intervention capacity is constrained, private recapitalization decisions become strategic complements, leading to equilibria with extremely high forbearance and high systemic costs of bank failure.