Strategic Creditor Passivity, Regulation, and Bank Bailouts

This paper analyzes two interrelated aspects of banking crises: the choices that banks make between actively pursuing satisfaction of their claims in default versus passively rolling over loans; and choices by regulators to "punish" passive and insolvent banks versus rescuing them. Because a bank's actions may signal its poor financial condition or because a bank may wish to gamble for resurrection, a bank with financial problems may choose to passively roll over its bad loans rather than to initiate bankruptcy against a defaulter. Regulators can play a crucial role in preventing creditor passivity, through their ex ante choice of monitoring capability and through their ex post choice of policy for insolvent or passive banks. Increasing the degree of monitoring, together with the threat of ex post punishment for passive behavior, can lower the level of passivity. Yet, if too many banks are discovered to be passive or insolvent, a situation labeled "too many-to-fail" (TMTF) may arise, whereby it is less costly to rescue banks than to close large numbers of banks or to fire the bank managers. Banks may implicitly collude through their choice of actions in order to trigger TMTF. One result of the analysis is that attempts by the regulator to offer rescue in order to induce insolvent banks to use bankruptcy against their defaulters and to reveal their insolvency may fail if ex ante monitoring capability is too weak or if the recapitalization accompanying rescue is not sufficiently generous. Rescue and recapitalization may thus need to be repeated in the future. Another principal result is that the regulator may react to the possibility of banks' triggering TNTFF by "softening," either ex ante by lowering monitoring capacity or, ex post by rescuing insolvent and passive banks. The threat of TMTF may thus make it impossible for the regulator to implement tough banking regulation.