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How should regulators manage information during a banking crisis?

You’re faced with a banking crisis. As a regulator, you have information about the health of banks and what you are planning to do to resolve them. Revealing this information to the market may be tricky. If you disclose that you won’t provide capital to banks, depositors may run on banks. Alternatively, if a bailout is likely, banks could engage in excessive risk-taking. In our research, we studied a theoretical model of how a regulator with private information about its cost of providing capital could chose to resolve potential bank failures. 

Research Summary

In the subprime crisis and European sovereign debt crisis, a recurrent theme is uncertainty about whether regulators could and/or would support banks at risk. Regulators must take into account that their actions today reveal something about what they will do next. For example, bailing out a bank today may be interpreted by the market as a signal that future bailouts may occur. Therefore a regulator may take actions to manipulate the market’s beliefs.

When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (1) a regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (2) a regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs.

The first effect may partly explain the Lehman episode and tough talk by German authorities about being unable to rescue banks. The second effect is reminiscent of Ireland’s guarantee of their banking sector, despite limited funds.

Research publication

Read the research. Shapiro, Joel and Skeie, David R. (2015) Information Management in Banking Crises. Review of Financial Studies, 28 (8). pp. 2322-2363.

Contact

 

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Other authors

David Skeie, Assistant Professor of Finance, Texas A&M