Banking Crises and Bank Rescues: the Role of Reputation

Abstract

This paper focuses on bank rescue packages and on banks' responses to rescue offers made during banking crises. A puzzling feature of experience with banking crises is that in many cases policy authorities make offers of bank rescue, but banks are reluctant to accept these offers. Asymmetric information between banks and outsiders regarding the extent of bad loans on banks' balance sheets is a common feature of banking crises. We study situations in which regulators have decided to offer rescue plans, and we show that banks' reputational concerns can have implications for the circumstances under which they will accept rescue offers. Even when the conditions accompanying a recapitalization plan are very "soft," banks may refuse to accept the offer. In order to compensate bankers for the negative reputational effects of accepting the plan, regulators may have to offer large amounts of recapitalization that are unrelated to the degree of the banks' solvency. In an optimal rescue plan the regulator will refrain from imposing punishment on banks that accept recapitalization; however, the regulator will impose costs on bankers who reject the rescue offer then perform poorly. Yet, even when the regulator takes account of bankers' reputational concerns in designing a rescue plan, rejection of the plan may occur in equilibrium. Strong bank supervisory systems aid the regulator who opts for bank rescues: when bank supervision is strong, banks will accept an offer of rescue with a lower amount of recapitalization than when bank supervision is weak. This suggests one explanation for international differences in experience with bank rescues.