Bank Regulatory Closure Policies: A Market-Based Approach
At the peak of the subprime crisis, the Federal Deposit Insurance Corporation (FDIC) showed latitude and laxity in resolving and closing insolvent institutions. Rather than automatically close systemically important insolvent banks, the FDIC revived them by infusing funds, Ronn and Verma (1986) call the tolerance level below which a bank closure is triggered the regulatory policy parameter. We made this policy parameter stochastic and bank specific and provide an extension of Lai (1996) model and implement it empirically to derive the market view of regulatory closure rules manifested via this policy parameter. Our two-factor structural model, in which the regulatory policy parameter is modeled as mean-reverting stochastic process delivers a closed form solution for the bank market capitalization. We then calibrate the model to over 600 U.S. banks’ data to infer information about the market perception of the regulatory closure rules during 1990 to 2009. In the empirical analysis, we link the market-based policy parameters to business cycles and bank specific risk variables, and find that the market expects banks to receive more (less) forbearance in bad (good) times, and the market expectations of closure rules are consistent with the risk attitude of banking regulators.