RFS Advance Access originally published online on December 5, 2007
Review of Financial Studies 2008 21(6):2705-2742; doi:10.1093/rfs/hhm078
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Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures
London Business School and CEPR
Federal Reserve Bank of New York
Address correspondence to Viral Acharya, Department of Finance, London Business School, Regent's Park, London NW1 4SA, UK. E-mail: vacharya{at}london.edu.
JEL Classification: G21, G28, G38, E58, D62
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Abstract |
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As the number of bank failures increases, the set of assets available for acquisition by surviving banks enlarges but the total liquidity available with surviving banks falls. This results in "cash-in-the-market" pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show, however, that there exists a policy that involves granting liquidity to surviving banks in the purchase of failed banks, which is equivalent to the bailout policy from an ex-post standpoint. Crucially, this liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and thereby dominates the bailout policy from an ex-ante standpoint.
This paper has been written and accepted for publication when Tanju Yorulmazer was at the Bank of England. We are grateful to Mark Flannery, Xavier Freixas, Douglas Gale, Denis Gromb, Lixin Huang, Christopher James, Charles Kahn, Jose Liberti, Matej Marinc, Robert Marquez, Enrico Perotti, Rafael Repullo, João Santos, Hyun Shin, Javier Suarez, Raghu Sundaram, Anjan Thakor, Lucy White, Andrew Winton, and two anonymous referees for the Bank of England Working Paper Series and the Review of Financial Studies (RFS) and the editor of RFS (Tobias Moskowitz) for useful suggestions. We would like to thank Prasanna Gai, Celine Gondat-Larralde, Andrew Gracie, Glenn Hoggarth, Erlend Nier, Sypros Pagratis, Lea Zicchino, and seminar participants at the London Business School, University of Vienna, Cass Business School, Bank of England, Judge Institute of Management at Cambridge, Norwegian School of Management, Tilburg University, University of Amsterdam, participants of the Financial Intermediation Research Society 2006 Conference, the Financial Fragility and Bank Regulation Conference at the Bank of Portugal, EFA 2006 Meeting, FDIC 6th Annual Bank Research Conference, and the Workshop on Risk Management and Regulation in Banking organized by BCBS, CEPR, and JFI in Basel for useful comments. All errors remain our own. The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Bank of England.
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