Cash-in-The-Market Pricing and Optimal Resolution of Bank Failures

Posted: 15 Dec 2008

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Tanju Yorulmazer

Koc University

Multiple version iconThere are 2 versions of this paper

Date Written: November 2008

Abstract

As the number of bank failures increases, the set of assets available for acquisition by surviving banks enlarges but the total liquidity available with surviving banks falls. This results in “cash-in-the-market” pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show, however, that there exists a policy that involves granting liquidity to surviving banks in the purchase of failed banks, which is equivalent to the bailout policy from an ex-post standpoint. Crucially, this liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and thereby dominates the bailout policy from an ex-ante standpoint.

Keywords: G21, G28, G38, E58, D62

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Yorulmazer, Tanju, Cash-in-The-Market Pricing and Optimal Resolution of Bank Failures (November 2008). The Review of Financial Studies, Vol. 21, Issue 6, pp. 2705-2742, 2008, Available at SSRN: https://ssrn.com/abstract=1315612 or http://dx.doi.org/hhm078

Viral V. Acharya (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

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HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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Centre for Economic Policy Research (CEPR) ( email )

London
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European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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Belgium

National Bureau of Economic Research (NBER) ( email )

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Tanju Yorulmazer

Koc University ( email )

Rumeli Feneri Yolu
Sariyer, Istanbul, 34450
Turkey

HOME PAGE: http://gsssh.ku.edu.tr/en/departments/economics/akademik-kadro/show/tyorulmazer/

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