Working Paper No. 328
By Viral Acharya and Tanju Yorulmazer
As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in 'cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.