May 15, 2019

ESRB published a working paper on bank capital forbearance. The authors of the paper have analyzed the interplay between banks and a supervisor after the latter discovers that a significant mass of banks may turn insolvent unless they get properly recapitalized. The analysis disentangles the strategic interaction between undercapitalized banks and a supervisor that may intervene by preventive recapitalization. The paper discusses the determinants of the credibility of the underlying public recapitalization threat and its impact on banks’ private recapitalization decisions, the resulting level of supervisory forbearance, and its implications for the systemic costs due to bank failure.

The paper describes the baseline model, characterizes the equilibrium of the baseline game between weak banks and the supervisor, discusses its comparative statics, and elaborates on the predictions regarding the effect of bank leverage on the equilibrium outcomes. The paper also provides a discussion of the welfare implications of the results and the inefficiency derived from the lack of supervisory commitment to intervene. 

The analysis offers a number of testable predictions and several important policy implications.

  • First, it predicts that, ceteris paribus, when supervisors face higher political or reputational costs of early intervention, banks’ private recapitalizations will be less frequently observed, public recapitalizations will be more frequently observed, and the systemic costs of bank distress will be larger, evidencing a larger level of forbearance. 
  • Second, the results predict that the incidence of public recapitalizations of damaged banks will tend to be higher in economies with more highly levered banks, while the overall incidence of capital forbearance will be non-monotonically related to bank leverage. 
  • Third, the results predict that economies facing a higher cost of early intervention, or a limit to their capacity to publicly recapitalize banks at some early stage, are more exposed to suffer from a negative feedback loop. In this loop, the softer threat of public intervention discourages banks from privately recapitalizing, increases or exhausts the usage of the supervisor’s intervention capacity, and rises the resulting forbearance and systemic costs. 

The findings also have important policy implications. The comparative statics of the private recapitalization cost and the analysis of the role of leverage suggest that policies reducing the importance of the Merton’s put (such as controls on leverage and risk taking by banks) or facilitating the undertaking of leverage reduction transactions can reduce the need for public intervention on trouble banks and the levels of forbearance. The analysis of the too-many-to-recapitalize problem, the possibility of having a supervisory-based sovereign-bank nexus, and the welfare losses associated with the lack of commitment of the supervisor to a tough early intervention policy have implications for the institutional design of the supervisory agencies in charge of early intervention on troubled banks.

 

Related Link: Working Paper (PDF)

 

Keywords: Europe, EU, Banking, Recapitalization, Systemic Risk, Capital Requirements, Early Intervention Measures, Bank Recapitalization, Banking Supervision, Research, ESRB

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