The dynamic liquidation of banks’ bad loans

Abstract

We consider the optimal dynamic liquidation of banks’ bad loans. The banks’ liquidation strategy affects the value of collateral and hence other firms’ access to credit. In this framework we characterize the socially optimal liquidation path. We show that the ’liquidate immediately’ strategy is optimal in a small banking crisis whereas the ’liquidate gradually’ strategy is optimal in a large banking crisis. It is argued that liquidation is likely to be postponed at society’s cost when the regulator has a short time horizon. We apply our analysis to the Japanese banking crisis.