Optimal design of bank bailouts: The case of transition economies

The paper proposes a framework to analyze the effects of various bank bailout policies on bank managers' incentives first to lend prudently and second to disclose truthfully their non-performing loans. It is shown that tough bank closure rules have counterproductive effects on bank managers' incentives to invest and disclose prudently. Soft bailout policies create incentives to overstate loan losses to obtain larger recapitalizations. Such policies do not necessarily create moral hazard problems in lending. The paper characterizes the second-best recapitalization policy, which involves transfers conditional on the liquidation of non-performing loans. It is shown that the second-best recapitalization policy creates the same incentives for prudent lending as though bank closure rules.