When a nation’s banks experience major losses, depositors, the markets,and regulators respond. The market responds by making it difficult for the bank to raise funds. Depositors may rush to withdraw funds from the banks. The regulators respond by closing banks, guaranteeing their liabilities, or recapitalizing them. One or more of these outcomes is inevitable. This article studies the effects of the regulatory choice on various parties in the economy.
The most obvious choice that regulators make is whether to let banks fail. Does their inability to raise sufficient private capital indicate that they are not viable or produce future services that are worth less than their cost, and thus should be closed? Only if the government, depositors, and borrowers were first allowed to jointly renegotiate would the inability to restructure indicate that the banks are not viable. This article analyzes the effects and desirability of recapitalizing banks with public funds, with a brief discussion of the implications of recapitalization for the current situation in Japan. In many countries, including Japan, there is a very deep government safety net and substantial regulation (see Ito and Sasaki [1998] and Hogarth and Thomas [1999] for discussions of bank capital structure in Japan). So one approach would be to ignore the markets and analyze bank recapitalization as a bargaining situation between banks and regulators. However, there islegislation in Japan that will limit deposit insurance (see Nakaso [1999]) and require prompt corrective action from undercapitalized banks, as is now required in the United States. Around the world, the discipline of banks relies to some extent on market incentives. As a result, it is important to study the effects of bank capital on how much banks will be able to raise in the market. Even with total deposit insurance, the banks will need to consider the effects of their credit rating on the other lines of business they can provide. If the level of capital is below the minimum necessary to stay in business (and this minimum will actually be enforced), then banks will need to do whatever it takes to increase their capital to the minimum. This “whatever it takes” type of bank behavior could have undesired effects on the economy.
The remainder of the article has the following structure. Section 1 outlines the basic argument, without technical details. Section 2 discusses the effects of a bank’s capital on its behavior. Section 3 discusses the effect of bank capital on the way that banks treat their borrowers and on the endogenous payments made by borrowers. Section 4 discusses the policy choice tradeoffs in choosing how much capital to provide. Section 5 argues that banks without lending relationships and those with nonviable borrowers should not be recapitalized. Section 6 concludes the article.
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