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Forbearance and Prompt Corrective Action

Authors


  • We thank Peter DeMarzo, Robert Hall, Michele Tertilt, Kostas Tsatsaronis, Mark Wright, and seminar participants at the Bank for International Settlements, the 2005 Society for Economic Dynamics Conference, the 2005 Econometric Society World Congress, and the Research on Money and Markets Conference at the University of Toronto for helpful comments and suggestions. We are also indebted to Kenneth West (the editor) and two anonymous referees for their comments. All errors remain our responsibility. Kocherlakota acknowledges the support of NSF SES-0076315. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the Bank for International Settlements.

Abstract

This article investigates whether a bank regulator should terminate problem banks promptly or exercise forbearance. We construct a dynamic model economy in which entrepreneurs pledge collateral, borrow from banks, and invest in long-term projects. We assume that collateral value has aggregate risk over time, that in any period entrepreneurs can abscond with the projects but lose the collateral, and that depositors can withdraw deposits. We show that optimal regulation exhibits forbearance if the ex-ante probability of collapse in collateral value is sufficiently low, but exhibits prompt termination of problem banks if this probability is sufficiently high.

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