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Cash-in-The-Market Pricing and Optimal Resolution of Bank Failures

67 Pages Posted: 17 Mar 2005  

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Tanju Yorulmazer

University of Amsterdam - Faculty of Economics and Business (FEB)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2007

Abstract

As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in 'cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.

Keywords: Bailouts, Systemic risk, Banking crises, Lender of last resort, Too many to fail, Time inconsistency, Herding

JEL Classification: G21, G28, G38, E58, D62

Suggested Citation

Acharya, Viral V. and Yorulmazer, Tanju, Cash-in-The-Market Pricing and Optimal Resolution of Bank Failures (June 2007). EFA 2006 Zurich Meetings; Bank of England Working Paper No. 328. Available at SSRN: https://ssrn.com/abstract=685505 or http://dx.doi.org/10.2139/ssrn.685505

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Tanju Yorulmazer

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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