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Too Many to Fail - An Analysis of Time-Inconsistency in Bank Closure Policies

Posted: 22 Aug 2006  

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)

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Abstract

While the too-big-to-fail guarantee is explicitly a part of bank regulation in many countries, this paper shows that bank closure policies also suffer from an implicit too-many-to-fail problem: when the number of bank failures is large, the regulator finds it ex-post optimal to bail out some or all failed banks, whereas when the number of bank failures is small, failed banks can be acquired by the surviving banks. This gives banks incentives to herd and increases the risk that many banks may fail together. The ex-post optimal regulation may thus be time-inconsistent or sub-optimal from an ex-ante standpoint. In contrast to the too-big-to-fail problem which mainly affects large banks, we show that the too-many-to-fail problem affects small banks more by giving them stronger incentives to herd.

Keywords: Bank regulation, systemic risk, bailout, moral hazard, herding, too big to fail

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

Suggested Citation

Acharya, Viral V. and Yorulmazer, Tanju, Too Many to Fail - An Analysis of Time-Inconsistency in Bank Closure Policies. Journal of Financial Intermediation, Forthcoming. Available at SSRN: https://ssrn.com/abstract=925699

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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