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Bad Debts and the Cleaning of Banks' Balance Sheets: An Application to Economies in Transition

Posted: 1 Feb 2001  

Janet Mitchell

National Bank of Belgium - Department of Financial Stability; Centre for Economic Policy Research (CEPR)

Abstract

This paper develops a framework for analyzing tradeoffs between policies for cleaning banks' balance sheets of bad debt when asymmetric information exists between banks and regulators regarding the amount of bad debt. The framework consists of a two-tier hierarchy composed of a regulator, banks, and firms. Hidden information and moral hazard are present at each tier of the hierarchy. The analysis identifies two types of effects of the regulator's policy choice: a direct effect on the bank's willingness to reveal its bad loans versus hiding them via loan rollovers; and an indirect effect on firm borrower behavior as a function of the bank's response. The direct effect has an impact on the bank's asset values; the indirect effect has an effect on firm borrowers' asset values, which in turn feed back onto the value of bank assets. The framework is applied to analyze tradeoffs between three policies: a laissez-faire policy where banks are left to solve their own problems; transfer of debt from the banks to an asset management company, and cancellation of debt inherited from a previous regime.

Keywords: Banking crises, recapitalization, asset management companies, economies in transition

JEL Classification: G21, G28, P34

Suggested Citation

Mitchell, Janet, Bad Debts and the Cleaning of Banks' Balance Sheets: An Application to Economies in Transition. Journal of Financial Intermediation. Available at SSRN: https://ssrn.com/abstract=251008

Janet Mitchell (Contact Author)

National Bank of Belgium - Department of Financial Stability ( email )

14 Blvd de Berlaimont
B-1000 Brussels
Belgium
+32 2 221 3459 (Phone)
+32 2 221 3104 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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