Collective strategic defaults: Bailouts and repayment incentives

Abstract

This paper shows that under a global games approach banks may be subject to risk of failure even when fundamentals are strong due to a coordination problem among debtors. As a result of collective strategic default a financially sound firm may claim inability to repay if it expects a sufficient number of other firms to do so as well, thus reducing bank's enforcement ability. This occurs in particular when financial environment is characterized by inadequate bankruptcy laws and poor quality of corporate sector. The paper provides a model in which participants take simultaneous actions on the basis of imprecise private signals about the ratio of bad loans in bank portfolio. The model has a unique equilibrium in which an attack against the bank occurs when its fundamentals are above some threshold level. The model also helps us understand the role of the Central Bank as a Lender of Last Resort under opportunistic behavior from borrowers. While an ex-post bailout policy is often believed to reduce bank incentives, in this case it induces commercial banks to affect loan quality, which indirectly reduces incentives for strategic default. Within this framework we argue that the marginal cost of intervention incurred by Central Bank has a double-edge effect. While a higher cost helps to mitigate the moral hazard problem at the bank level by determining it to exert maximum of effort even when fundamentals are strong, it also increase the probability of bank failure by lowering the threshold in fundamentals that triggers collective strategic default. We also find that high bank expected profitability reduces the likelihood of collective strategic default