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Abstract
It is generally considered important that a banking crisis be resolved quickly to minimize the adverse effects that arise from distorted incentives caused by the operation of insolvent financial institutions. Depending on the nature of the crisis, the authorities can apply a number of support measures. An injection of short-term liquidity into the affected banks would be sufficient in a mere liquidity crisis. In circumstances such as the Nordic banking crises that are characterized by widespread solvency problems, a more active government role is usually required. In such situations, authorities face the choice of providing capital to a troubled bank without any change in its ownership and operation (sometimes referred to as “open-bank assistance”), or taking the bank over and runing it as a publicly owned institution. Alternatively, the government may choose either to liquidate the insolvent bank and pay off depositors and other creditors (not necessarily in full) or to sell the troubled bank through a so-called purchase and assumption agreement. Regardless of which specific method of bank support is chosen, the incentives that accompany government bank support should be analyzed carefully to minimize the overall costs of the operation and to keep the distortions created by government intervention small.
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