Catharsis − The real effects of bank insolvency and resolution

In general, banks play a growth-enhancing role for the real economy. However, distorted incentives for banks, depositors, and regulators in connection with bank insolvency may corrupt banks' credit allocation and monitoring decisions, leading to suboptimal real economic outcomes. A rules-based prompt resolution regime for insolvent banks may reestablish the incentive system and provide for economically superior credit allocation and monitoring. We test the hypothesis that regulatory insolvency has a cathartic e ect using a large rm-level dataset and proposing a new indicator to measure the strength of catharsis. Employing an instrumental variable setup and an interaction approach, we try to overcome concerns about causality and potential endogeneity which are usually inherent to research into the real economic implications of bank regulation. We nd a comparably stronger implementation of a hypothetical positive capital closure rule to have a positive and statistically as well as economically signi cant e ect on individual rm growth particularly for rms that are structurally more dependent on bank nancing. Our ndings are robust to various speci cations. Investigating the transmission channels of the `catharsis e ect', we nd that it essentially works through bene ting better quality rms and reallocating credit towards rms that need it most. Additional analyses suggest that the `catharsis e ect' works best in open banking systems that provide high access to international nance and, hence, mitigate potentially negative credit supply e ects of insolvent bank liquidation. Taken together, our ndings advocate stronger attention being given to incentive-compatible bank resolution regimes. JEL classi cation: G21, G28, G33