Too Many to Fail - An Analysis of Time-Inconsistency in Bank Closure Policies
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Federal Reserve Bank of New York
Journal of Financial Intermediation, Forthcoming
While the too-big-to-fail guarantee is explicitly a part of bank regulation in many countries, this paper shows that bank closure policies also suffer from an implicit 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 the risk that many banks may fail together. The ex-post optimal regulation may thus be time-inconsistent or sub-optimal from an ex-ante standpoint. In contrast to the too-big-to-fail problem which mainly affects large banks, we show that the too-many-to-fail problem affects small banks more by giving them stronger incentives to herd.
Keywords: Bank regulation, systemic risk, bailout, moral hazard, herding, too big to fail
JEL Classification: G21, G28, G38, E58, D62
Date posted: August 22, 2006
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