The Costs of Closing Failed Banks: A Structural Estimation of Regulatory Incentives

The Formation of Hidden Negative Capital in Banking: A Product Mismatch Hypothesis

“…However, during periods of financial turbulence, the bank capital adequacy ratio can not only fall below the regulatory thresholds but, depending on the size of shocks, even further below zero thus rendering bank capital negative. In the latter case, troubled banks have huge incentives to falsify their financial statements by reporting artificially sufficient positive levels of capital to keep their licences, thus engaging in fraud and insider abuse (James, 1991;Kang et al, 2015;Cole and White, 2017). 1 These banks essentially operate with hidden negative capital (hereinafter, HNC) which is likely to bear certain -and possibly very large -losses to society.…”

“…HNC can be treated as a consequence of either incorrect business decisions of bank managers (bad luck in the spirit of Berger and DeYoung, 1997) or banks' illegal activities and falsifications. Previous research has identified several signals that are associated with negative capital in banks (James, 1991;Kang et al, 2015): a lack of capital 2 , higher portion of non-performing loans, and income earned but not collected, among others (see Section 2 for further details). However, negative capital can also be associated with either product, risk, or liquidity mismatches, though, to the best of our knowledge, neither has been examined in this context.…”

“…For instance, household deposits may appear to be more expensive compared to corporate deposits (the liabilities side) and, normally, credit to households is likely to be charged with a higher interest rate than 1 By overreporting its capital, a troubled bank may hope that the situation will later improve thus allowing the bank to turn back to fair capital reporting. This can be possible if, during the financial turbulence, either the too-many-to-fail effect materializes (Acharya and Yorulmazer, 2007;Brown and Dinç, 2011) or the central banks decide to postpone the costs of bank failures to future due to, for instance, high monetary and/or non-monetary costs associated with the closure of particular troubled banks in the current period (the regulatory forbearance effect, see, e.g., Kang et al, 2015).…”

“…First, the theory of bank capital states that a bank can operate with HNC as long as it is able to maintain the confidence of its creditors. Second, banking systems are also subject to excessive regulatory forbearance (Wheelock and Wilson, 2000;Kang et al, 2015;Cole and White, 2017), meaning that regulators are unable to process license revocation faster than they do. This is because of either (i) informational asymmetry and possible political pressure (Brown and Dinç, 2005;Kang et al, 2015), (ii) a government budget deficit when the banking system is weak (Brown and Dinç, 2011), or (iii) the risk of missing the opportunity to sell failing banks to healthier banks (Bennett and Unal, 2014;Granja et al, 2017).…”

“…Second, banking systems are also subject to excessive regulatory forbearance (Wheelock and Wilson, 2000;Kang et al, 2015;Cole and White, 2017), meaning that regulators are unable to process license revocation faster than they do. This is because of either (i) informational asymmetry and possible political pressure (Brown and Dinç, 2005;Kang et al, 2015), (ii) a government budget deficit when the banking system is weak (Brown and Dinç, 2011), or (iii) the risk of missing the opportunity to sell failing banks to healthier banks (Bennett and Unal, 2014;Granja et al, 2017). However, a bank cannot operate with HNC forever: A recent study by Berger and Bouwman (2013) shows that bank capital matters for retaining 3 Among the latter, private deposit holders are likely to be less aware of banking problems due to informational asymmetry (Diamond and Rajan, 2000) and the rational inattention argument.…”