DP13718 Optimally solving banks' legacy problems

Author(s): Anatoli Segura Velez, Javier Suarez
Publication Date: May 2019
Keyword(s): Debt overhang, deposit insurance, non performing loans, optimal intervention, state aid
JEL(s): G01, G20, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13718

We characterize policy interventions directed to minimize the cost to the deposit guarantee scheme and the taxpayers of banks with legacy problems. Non-performing loans (NPLs) with low and risky returns create a debt overhang that induces bank owners to forego profitable lending opportunities. NPL disposal requirements can restore the incentives to undertake new lending but, as they force bank owners to absorb losses, can also make them prefer the bank being resolved. For severe legacy problems, combining NPL disposal requirements with positive transfers is optimal and involves no conflict between minimizing the cost to the authority and maximizing overall surplus.