Capital Forbearance in the Bank Recovery and Resolution Game

Abstract

We analyze the strategic interaction between undercapitalized
banks and a supervisor in the context of a recovery and resolution framework
in which early recapitalizations can prevent later disorderly failures.
Capital forbearance emerges because reputational, political, economic and
fiscal costs undermine supervisors' commitment to publicly resolve the banks
that miss the request to privately recover. Under a weaker resolution
threat, banks' incentives to recover are lower and supervisors may end up
having to resolve more banks. When resolution capacity is constrained (e.g.
for fiscal reasons), private recovery actions become strategic complements,
producing equilibria with extremely high forbearance and high systemic
costs.

Keywords: bank supervision; bank recapitalization; forbearance

JEL Classification: G21; G28