AN OPTIMAL SCHEME FOR INJECTING PUBLIC FUNDS UNDER THE MORAL HAZARD INCENTIVE FOR BANKS

Abstract

I consider whether the injection of cash funds into a bank through the purchase of securities together with a bank closure policy can be designed as a strong incentive instrument for preventing the bank from taking moral hazard action in the presence of deposit insurance. Under certain conditions, the regulator’s optimal policy can be to inject new cash funds into a bank through the purchase of securities, even though there are no bankruptcy costs. Furthermore, the regulator may transform the private bank into a government-owned bank. However, this kind of injection policy cannot be independent of the bank closure policy.