The Disposition of Failed Bank Assets: Put Guarantees or Loss-Sharing Arrangements

Abstract

To mitigate the regulatory losses associated with bank failures, efforts are usually made to dispose of failed bank assets quickly. However, this process usually precludes due diligence examination by acquiring banks, leading to problems of asymmetric information concerning asset quality. This paper examines two mechanisms that have been used for dealing with these problems, ”put guarantees,” under which acquiring banks are allowed to return assets to the regulatory authority for liquidation, and ”loss-sharing arrangements,” under which the acquiring banks keep all assets under their control to maturity and are then compensated by the regulatory authority for a portion of asset losses. The analysis is conducted in a Hart-Moore framework in which the removal of certain assets from the banking system can reduce their value. Changes in the relative desirability of the two guarantee mechanisms during economic downturns are shown to depend on the credibility of the regulatory authority. When the regulatory authority enjoys credibility, a downturn favors the loss-sharing arrangement, while when the regulatory authority lacks credibility, the impact of a downturn is ambiguous. J.E.L. Classification Number: G21, G38