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International Monetary Fund and Department of Applied Economics, University of Cambridge, respectively. Mr. Perraudin was an Economist in the Research Department of the Fund when this paper was written. The authors thank Leonardo Bartolini, Donald Mathieson, and Lars Svensson for useful discussions.
Clearly, if audits were costless and hence could be carried out on a continuous basis, the government’s liability would be zero in such models.
The terms closure and financial reorganization are used interchangeably.
Note that this description of absorption is from the point of view of the shareholders who lose any claim to the earnings stream after it hits e for the first time.
We assume that the bank’s shareholders would have sufficient net worth to satisfy any claim against them under unlimited liability.
In problems with reflecting barriers, as in the band exchange rate models of Froot and Obstfeld (1991b) and Perraudin (1991), smooth pasting conditions hold even without optimally chosen barriers. In such cases, optimality generally implies additional conditions upon the second derivatives of the solution evaluated at the barriers. For a discussion, see Dixit (1991).
These two phenomena are not completely distinct since, for example, changing dividend policies so as to increase the portion of earnings that is reinvested, could be regarded as increasing μ at the same time as cutting the current level of earnings, et.
The transfers may also be to managers or other employees of the bank in the case of malfeasance.
Note also that a deposit insurance premium levied on a per dollar of deposit basis lowers the incentive to substitute at the margin deposits for equity, whereas a lump-sum premium does not.
His analysis is actually more general and does not require the existence of a representative agent but it is simpler to think in these terms.
One complication is that bond contracts, especially for private sector borrowers, are generally fairly short maturity.