Banking Crises and Bank Rescues:
When Regulators Become Soft to Get Tough

Professor Janet Mitchell

(Facultés Universitaires de Saint-Louis and CEPR)

In recent years banking crises have afflicted many countries throughout the world. Regulators’ responses to these banking crises have varied widely, ranging from multiple bank closures (Argentina and the U.S.A) to widespread bank rescues (Norway, Sweden, Japan, Hungary, Czech Republic and Bulgaria). Why do regulators in some instances apply tough policies to troubled banks and in other instances rescue many of them? Janet Mitchell, in a lunchtime briefing organized for CEPR corporate members, argues that the notion of ‘too-many-to-fail’ explains multiple bank rescues. If too many banks in an economy are financially troubled, the social costs of closing all of them down may exceed the costs of rescuing them.

Yet, regulators may realize that they risk being trapped in a situation of ‘too-many-to-fail,’ and they may take measures to eliminate this risk. One such measure is to weaken bank regulation. By weakening regulation (e.g., definitions of bank solvency) regulators diminish their own ability to detect troubled banks but simultaneously increase the credibility of the threat to be tough with the financially troubled banks that are actually discovered. Becoming soft in regulation can permit regulators to be tough in banking crises.

Regulators’ responses to banking crises thus depend upon a number of factors, including how the banks themselves have handled their bad loans; what type of banking regulation was in place prior to the crisis; and the total number of banks suffering financial distress. Troubled banks often attempt to hide their loan losses by passively rescheduling loans in default. This behavior can exacerbate a crisis: regulators may not detect the problem until the crisis has become very serious or widespread. The number of banks suffering from financial distress is also important. Whereas the well accepted notion of ‘too-big-to-fail’ explains rescues of certain individual banks observed in different countries, it cannot explain the simultaneous rescue of several banks. ‘Too-many-to-fail’ captures the notion that multiple bank closures can generate high social costs—arising from reductions in output of firms that are deprived of finance and from significant resource costs required to impose tough policies on many troubled banks—that exceed the costs of rescues.

Banks’ handling of their bad loans will depend upon the nature of existing bank regulation and upon on bankers’ expectations regarding the regulators’ policy response to a banking crisis. The expectation that troubled banks will be rescued can encourage banks to passively roll over loans. In response to the fear of being trapped in a situation of ‘too-many-to-fail’, regulators may actually weaken regulation. Applying a tough policy to a smaller number of troubled banks (and allowing some troubled banks to go undiscovered) can be less costly than detecting more troubled banks but being forced to rescue them. This result suggests that in emerging market economies and in economies in transition where the risk of systemic banking crises is high, it may be impossible for regulators to implement tough banking regulations without running the risk of a bailout of the entire banking system. The outcome may be only a gradual evolution of banking regulation over time, as the risk of a systemic banking crisis subsides.

Notes for Editors:

CEPR is a network of over 450 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps its Research Fellows to develop projects, obtain their funding, administer them and disseminate their results. The Centre’s research ranges from open economy macroeconomics to trade policy, from the economic transformation of Central Eastern Europe to regionalism in the world economy. The views expressed in the discussion meeting are the author’s own. CEPR is an ESRC Resource Centre.

Janet Mitchell is Professor of Economics at ECARE, Université Libre de Bruxelles and a Research Fellow in CEPR’s Transition Economies programme.

Strategic Creditor Passivity, Regulation and Bank Bailouts
Discussion Paper No.1780
Janet Mitchell, Université Libre de Bruxelles

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