DP9612 Information Management in Banking Crises

Author(s): Joel Shapiro, David Skeie
Publication Date: August 2013
Keyword(s): bank regulation, financial crisis, reputation, sovereign debt crisis, stress tests
JEL(s): G01, G21, G28
Programme Areas: Financial Economics
Link to this Page: http://www.cepr.org/pubs/dps/DP9612

A regulator resolving a bank faces two audiences: depositors, who may run if they believe the regulator will not provide capital, and banks, which may take excess risk if they believe the regulator will provide capital. When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (i) A regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (ii) A regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs. Regulators perform more informative stress tests when the market is pessimistic.