Optimally Solving Banks' Legacy Problems

Abstract

We characterize policy interventions directed to minimize the cost to the deposit guarantee scheme and the taxpayers of banks with legacy problems. Non-performing loans (NPLs) with low and risky returns create a debt overhang that induces bank owners to forego profitable lending opportunities. NPL disposal and provisioning requirements can restore the incentives to undertake new lending but, as they force bank owners to absorb losses, can also make them prefer the bank being liquidated. For severe legacy problems, combining those NPL-targeted interventions with positive transfers is optimal and involves no conflict between minimizing the cost to the authority and maximizing overall surplus.

Keywords: Debt overhang, deposit insurance, non performing loans, optimal intervention, state aid

JEL Classification: G01, G20, G28