Theories of Soft Budget Constraints and the Analysis of Banking Crises

Abstract

This paper proposes a new taxonomy for classifying models of soft budget constraints (SBCs) which allows identification of two classes of models. Disctinction between these classes is useful, as they yield SBCs in differing circumstances and have differing theoretical and policy implications. The taxonomy is used to discuss an area in which SBC models can yield novel insights: the analysis of banking crises. A model is presented in which SBCs have implications for the policy tradeoffs faced by regulators in dealing with bad debts on troubled banks' balance sheets. The paper compares several SBC models analyzing differing aspects of banking crises and identifies the range of issues which each class of SBC models can address.

JEL Classification: G2, G28, P2