Government Interventions in Banking Crises: Effects of Alternative Schemes on Bank Lending and Risk Taking

Abstract

We analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allow banks to influence the scale of assistance and externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives, but may have higher fiscal costs.