Too many to fail - an analysis of time-inconsistency in bank closure policies

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 26 January 2007

Working Paper No. 319
By Viral Acharya and Tanju Yorulmazer

While the 'too-big-to-fail' guarantee is explicitly a part of bank regulation in many countries, this paper shows that bank closure policies also suffer from an implicit 'too-many-to-fail' problem: when the number of bank failures is large, the regulator finds it ex-post optimal to bail out some or all failed banks, whereas when the number of bank failures is small, failed banks can be acquired by the surviving banks. This gives banks incentives to herd and increases the risk that many banks may fail together. The ex-post optimal regulation may thus be time-inconsistent or suboptimal from an ex-ante standpoint. In contrast to the too-big-to-fail problem which mainly affects large banks, we show that the too-many-to-fail problem affects small banks more by giving them stronger incentives to herd.

PDF Too many to fail — an analysis of time-inconsistency in bank closure policies 

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