Information Management in Banking Crises

Abstract

A regulator resolving a bank faces two audiences: depositors, who may run if they believe the regulator will not provide capital, and banks, which may take excess risk if they believe the regulator will provide capital. When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (1) a regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (2) a regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs.