Preventing Zombie Lending

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