Government Interventions in Banking Crises: Assessing Alternative Schemes in a Banking Model of Debt Overhang

We evaluate policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or to choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allows banks to influence the scale of the assistance and to externalize risks, implying overinvestment or excessive risk taking or both. Assistance granted without reference to new activities, like establishing a bad bank, does not generate adverse incentives but may have higher fiscal costs.

29. April 2010

Authors Diemo Dietrich Achim Hauck

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Government Interventions in Banking Crises: Effects of Alternative Schemes on Bank Lending and Risk-taking

Diemo Dietrich Achim Hauck

in: Scottish Journal of Political Economy, No. 2, 2012

Abstract

We analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or to choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allows banks to influence the scale of the assistance and to externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives but may have higher fiscal costs.

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