Bad Debts and the Cleaning of Banks' Balance Sheets

Book excerpt: This paper develops a framework for analyzing tradeoffs between policies for cleaning banks' balance sheets of bad debt when asymmetric information exists between banks and regulators regarding the amount of bad debt. The framework consists of a two-tier hierarchy composed of a regulator, banks, and firms. Hidden information and moral hazard are present at each tier of the hierarchy. The analysis identifies two types of effects of the regulator's policy choice: a direct effect on the bank's willingness to reveal its bad loans versus hiding them via loan rollovers; and an indirect effect on firm borrower behavior as a function of the bank's response. The direct effect has an impact on the bank's asset values; the indirect effect has an effect on firm borrowers' asset values, which in turn feed back onto the value of bank assets. The framework is applied to analyze tradeoffs between three policies: a laissez-faire policy where banks are left to solve their own problems; transfer of debt from the banks to an asset management company, and cancellation of debt inherited from a previous regime.