Pre-emptive policy for systemic banking crisis

Systemic banking crises often result from widespread imprudent lending, driven by strong incentives for risk taking and connected lending. This paper identifies a counterbalancing incentive for in-dividual banks to act prudently in the face of widespread risk taking among its competitors. In general, the value of a banking charter is enhanced by reduced competition. Hence a deliberate policy of pro-moting takeovers of weaker institutions by solvent banks has the effect of increasing the charter value of solvent banks, and grants the managers of better banks an incentive to pursue less profitable but safer lending strategies, thus breaking down the strategic externality of risk-taking strategies. A temporary phase of concentration in banking can thus reinforce stability and pre-emptive closures may in fact reduce the risk of a systemic banking crisis. We also address the case where banking authorities face pressure for an ex post bailout in a context where many banks are in trouble at the same time.