Strategic Creditor Passivity, Regulation and Bank Bailouts

This paper analyses two aspects of banking crises: the choices that banks make to passively roll over loans in default versus actively pursuing their claims; and choices by regulators to ‘punish’ passive and insolvent banks versus rescuing them. Banks may choose to roll over loans in order to hide their poor financial conditions or to gamble for resurrection. Regulators can reduce creditor passivity through their ex-ante choice of monitoring capability and their ex-post choice of policy for distressed banks. Yet, if too many banks are discovered to be passive or insolvent, a situation labelled ‘too-many-to-fail’ (TMTF) may arise, whereby it is less costly to rescue than to close large numbers of banks. Banks may implicitly collude through their choice of actions in order to trigger TMTF. A principal result of the analysis is that when the regulator reacts to the threat of banks triggering TMTF, it is by ‘softening’. One form of softening involves lowering the ex-ante monitoring capacity and ‘punishing’ a smaller number of banks ex post. More undetected passivity will thus exist in equilibrium than if TMTF could not be triggered.