A positive analysis of bank failure resolution policies

Using a two bank, two-period game-theoretic model, this chapter shows that contingent purchase and assumption policy under which the choice of acquirer for a failed bank is contingent on the surviving banks’ risk-taking behavior is generally most effective in reducing moral hazard problems, particularly for countries with low levels of competition and high regulatory barriers. Moreover, we find that to minimize the probability of future bank failures, the choice of acquiring bank should be based not only on the short-term goal of resolving the insolvencies of financial institutions, but also on the long-term effects of ex ante risk-taking incentives.