Much of the literature on bank regulatory policy suggests that bank rescues are inefficient and can worsen banking sector problems. The whole tenor of prompt corrective action regulation is to avoid having to bail out inadequately capitalized banks; however, in many cases it is already too late for this type of policy response. If many banks become insolvent, policymakers are forced to recapitalize banking systems to avoid credit crunches and premature liquidations of both performing and nonperforming loans. This is the main reason that the International Monetary Fund frequently mandates restructuring packages that involve an element of bank recapitalization.

A puzzling fact is that in many cases policy authorities make offers of bank rescue plans, yet banks are reluctant to accept these offers. In recent years, private banks in both Japan and Thailand have been unenthusiastic about government offers of recapitalization. The failure to convince banks to recapitalize and to restructure and write off nonperforming loans has contributed to the poor performance of the real economy in both countries. By contrast, the Republic of Korea, Norway, and Sweden provide examples of relatively swift recapitalization. This article offers an explanation for these international variations that differs from those previously suggested in the literature.

The current literature does not explain why too few, rather than too many, banks come forward to accept government recapitalization offers. Although some anecdotal evidence suggests that some recapitalization programs failed because the conditions imposed on the banks were too stringent, other anecdotal evidence suggests that this is not the only source of reluctance to accept recapitalizations. Our explanation involves the banks’ reputational concerns.

This article investigates banks’ behavior during banking crises when asymmetric information exists between banks and outsiders regarding the extent of bad loans on the banks’ balance sheets. We show that asymmetric information creates an incentive for banks to roll over their nonperforming loans in an attempt to disguise their true financial situation. Even though a regulator may be able to combat this incentive by offering a "soft" rescue package, bankers’ reputational concerns may cause them to reject rescue offers and to continue with loan rollovers.

To induce banks to accept rescue plans and to address their problem loans, regulators may be forced to offer recapitalization in amounts that significantly exceed those necessary to restore banks to solvency. These additional funds serve to compensate bankers for the reputational harm caused by the revelation of bad loans that accompanies their acceptance of a rescue offer. If regulators are constrained in the amount of recapitalization they can offer, they may be unable to induce banks to accept rescue plans and to reveal their bad loans. Alternatively, they may have to wait until the banking crisis becomes severe and more banks become distressed before the banks are willing to accept rescue offers.

In addition to offering a potential explanation for several observed cases in which banks have refused offers of rescue during banking crises, our approach yields some insight into the link between bank supervisory institutions that are in place ex ante and the policy options that are available to regulators ex post, once a crisis has occurred. In countries with strong supervisory systems, regulators can induce banks to accept rescue plans with lower amounts of recapitalization than if the supervisory system were weak. This suggests the possibility of a vicious circle arising in countries with weak supervisory institutions, namely: weak banking supervision increases the probability of occurrence of a banking crisis, but once a banking crisis has developed, banks are unwilling to reveal their bad loans unless offered a large amount of recapitalization.

A novel policy implication of our analysis is that the optimal rescue plan imposes a cost on banks that reject rescue offers and then exhibit poor performance. By committing to punishing banks that reject rescue offers and are then discovered to be in poor financial shape, the regulator can induce troubled banks to accept rescue offers with less recapitalization than in the absence of such a commitment. If the cost of the punishment is high enough, the regulator can induce banks to accept rescue plans with only negligible recapitalization.

This result points to the informational role that bank rescue offers serve. A rescue offer forces a bank to take an explicit stand with respect to the presence of bad loans on its balance sheets. The bank’s acceptance or rejection of a rescue offer conveys information to bank outsiders—which they would not otherwise receive—about the severity of the banking crisis, the bank’s type, and the bank’s treatment of nonperforming loans. This creates the possibility of punishing banks that are discovered to be trying to hide their nonperforming loans. The ultimate effect of increased information generated by the offer of a rescue plan is to induce banks to reveal their defaulting loans more often than in the absence of rescue offers.

Yet banks may still decide to reject rescue offers. Even when the regulator takes into account bankers’ reputational concerns in designing a rescue offer, rejection of the rescue offer may occur in equilibrium. For example, the possibility exists that the high costs of recapitalization may result in an optimal plan whereby the regulator offers an amount of recapitalization that will only be accepted by banks if the crisis is severe enough, but if the crisis is less severe, banks will reject the offer.

Thus far our discussion and analysis have ignored depositor behavior. Like the market, depositors do not observe the state of the world or the bank’s type. When a bank rejects a rescue plan in period 1 and succeeds, depositors are unaware of the bank’s true financial state. However, we can reasonably assume that depositors do observe the bank’s true financial state in period 2. Therefore, even if a bank with loan defaults has succeeded in hiding those defaults in period 1, depositors will observe the bank’s true net worth in period 2 and can decide to exit the bank. This would impose an additional cost on the bank that rolled over its defaulting loans in period 1. Thus the more sensitive depositors are to banks’ solvency, the greater the costs to banks of rolling over nonperforming loans.

Similar observations apply to the cost the regulator imposes on troubled banks that have rejected rescue plans, but are subsequently discovered by the regulator. In this case depositors also immediately discover not only the existence of the bank’s defaulting loans, but also the bank’s attempt to deceive outsiders by hiding these loans. Depositors may react to this deception by immediately withdrawing their funds. The likelihood of such a response would increase banks’ willingness to accept rescue plans. Thus in countries where depositors exercise strong enough discipline, banks may be willing to accept rescue plans with only small amounts of recapitalization. The discipline exercised by depositors complements the discipline exercised by the regulatory system.