Should Banks Be Recapitalized?

W hen a nation’s banks experience major losses, depositors, the mar-kets, and regulators respond. The market responds by makingit difficult for the bank to raise funds. Depositors may rush to withdraw funds from the banks. The regulators respond by closing banks, guaranteeing their liabilities, or recapitalizing them. One or more of these outcomes is inevitable. This article studies the effects of the regulatory choice on various parties in the economy. The most obvious choice that regulators make is whether to let banks fail. Does their inability to raise sufficient private capital indicate that they are not viable or produce future services that are worth less than their cost, and thus should be closed? Only if the government, depositors, and borrowers were first allowed to jointly renegotiate would the inability to restructure indicate that the banks are not viable. This article analyzes the effects and desirabil-ity of recapitalizing banks with public funds, with a brief discussion of the implications of recapitalization for the current situation in Japan. In many countries, including Japan, there is a very deep government safety net and substantial regulation (see Ito and Sasaki [1998] and Hogarth and Thomas [1999] for discussions of bank capital structure in Japan). So one approach would be to ignore the markets and analyze bank recapitalization as a bargaining situation between banks and regulators. However, there i