Banking sector problems leading to bank insolvencies have been frequent in recent decades in developed and developing countries alike. The macroeconomic consequences of banking crises are well known. Moreover, financial distress helps in propagating the adverse shocks to the real sectors of the economy when banks reduce lending to creditworthy borrowers. The real effects of banking crises are worse for sectors that have very limited alternatives to bank financing, something that applies across the board in developing countries. Dell’Ariccia et al. (2008) find evidence in this regard and suggest that banks need to be supported during distress to prevent a vicious circle in which banking distress and economic contraction reinforce each other.
A sound banking system is often considered a public good essential for macroeconomic stability, so it is not surprising to see governments get drawn into the costly process of recapitalizing bankrupt banks in the aftermath of a banking crisis. Honohan and Klingebiel (2000) find that in their sample of 40 crisis-countries, governments end up bearing most of the direct costs of the crises. Fiscal resolution costs about 13% of GDP on average, and 14.3% in developing countries. According to Caprio and Klingebiel (1996), an overall estimate of the amount of resources involved in bank restructuring programs is between 10 and 20% of GDP in most cases and occasionally as much as 40-55% of GDP. All in all, banking crises are costly phenomena with serious adverse macroeconomic consequences and have enormous negative impact on the fiscal balance.
This paper characterizes Ramsey-optimal bank restructuring programs from the public finance viewpoint and seeks to answer the following question: once a government decides to recapitalize a bankrupt banking sector, what is the optimal path of a program that weights recapitalization benefits and the program’s costs, given the financing option available to the government? To the best of our knowledge, this is the first attempt at formally analyzing the problem of recapitalizing a bankrupt banking system in the aftermath of a banking crisis that takes into account the fact that the costs of recapitalization depend on the government’s sources of funding the program.
We analyze the resolution of a banking crisis once it has occurred and the government has already decided to restructure the economy’s bankrupt banking system. Thus, instead of focusing on panics or serious liquidity dry-outs, we focus on the aftermath of a banking crisis when a large fraction of the banking capital stock has already been eroded and the banking system is providing just a fraction of the efficient level of financial intermediation. We refer to recapitalization as the injection of banking capital that restores the ability of undercapitalized banks to intermediate financial credit at an efficient level.
We model a perfect foresight economy that is hit by an unforeseen banking crisis. Following the empirical literature, we define a banking crisis as an event in which a significant fraction of the bank capital is depleted (see Caprio and Klingebiel, 2003). Banks, modeled following Cole and Ohanian (2000), are financial intermediaries that borrow from house holds and lend to firms, which face a working-capital constraint requiring them to pay their wage bill before cashing their sales.
