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Preventing Zombie Lending

Review of Financial Studies, 27(3), pp 923-956.

49 Pages Posted: 21 Jun 2010 Last revised: 12 Mar 2014

Max Bruche

Cass Business School, City University London; Financial Markets Group (LSE)

Gerard Llobet

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR)

Date Written: October 2012

Abstract

Because of limited liability, insolvent banks have an incentive to continue lending to insolvent borrowers, 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 dealt with. Bank participation in the proposed 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, debt holders can be made to shoulder part of the costs of the scheme as long as the regulator can credibly commit not to bail out a bank whose debt holders do not accept a reduction in the face value of their debt.

Keywords: bank bail-outs, forbearance lending, recapitalizations, asset buybacks, mechanism design

JEL Classification: G21, G28, D86

Suggested Citation

Bruche, Max and Llobet, Gerard, Preventing Zombie Lending (October 2012). Review of Financial Studies, 27(3), pp 923-956.. Available at SSRN: https://ssrn.com/abstract=1628170 or http://dx.doi.org/10.2139/ssrn.1628170

Max Bruche (Contact Author)

Cass Business School, City University London ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (20) 7040 5106 (Phone)
+44 (20) 7040 8881 (Fax)

HOME PAGE: http://www.maxbruche.net

Financial Markets Group (LSE) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Gerard Llobet

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
SPAIN
34 91 429 0551 (Phone)
34 91 429 1056 (Fax)

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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