Bank Restructuring without Government Intervention

Abstract

When a bank is burdened with Non Performing Loans, an underinvestment problem may arise. Banking Authorities often take the initiative to segregate these Non Performing Loans into a Bad Bank (BB), so that the remaining part of the bank, the Good Bank, finds it profitable to make new loans. These BBs typically involve an injection of public funds. We propose a different type of bank break up that does not require any government subsidy. The idea is to give to the bank’s shareholders the option to create a BB on their own, and finance it ex-ante by requiring the bank to issue a bail-inable bond that is drawn down when the option is exercised. No tax payer money is involved. Such a restructuring differs from the bail-in regimes in the Bank Recovery and Resolution Directive in the EU and the Dodd-Frank Act in the USA in that it recognizes to the bank’s shareholders the information rents that result from their private information on the bank’s legacy loans.