RIETI Discussion Paper Series 03-E-007

In some recent financial crises, most of the domestic banks or the banking sector as a whole has become insolvent. We analyze the welfare effects of policy responses to bank insolvency by examining a modified version of the Diamond-Rajan model, in which we introduce fiat currency. The sources of inefficiency in our model are moral hazard in banking and the premature liquidation of bank assets. We assume that insolvency of the banking system is caused by an exogenous macroeconomic shock that destroys a portion of banks ' assets. If the government does not intervene in a very severe case of bank insolvency, a fire sale of all bank assets occurs, the economy becomes disintermediated, and price levels may fall (¥emph{debt deflation}). We analyze the consequences of different policy responses to bank insolvency: (1) a deposit guarantee (without immediate recapitalization), (2) unlimited liquidity support, and (3) bank recapitalization through either cash creation (monetary policy) or bond issuance (fiscal policy). We show that bank recapitalization by fiscal measures isoptimal in our model. Our findings imply that Japan's protracted recession and deflation may have been caused by an inappropriate policy response to bank insolvency