Mechanism Design of Bank Bailout Policy

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Under the incomplete contract framework, we consider an optimal regulatory policy for motivating bank equity owners and bank managers to restructure the bad loans of their banks in the presence of managerial compensation contracts with stock options. The regulatory policy studied in this paper is mainly concerned with the design of repayment schedules in the scheme of injection of cash funds into insolvent banks by the regulator. We show that the regulator cannot necessarily attain the social optimal allocation by injecting cash funds into insolvent banks through the purchase of subordinated bonds with the risk-free interest rate. However, even in that case, we also suggest that, if the regulator injects cash funds into active restructuring banks through the purchase of subordinated bonds or preferred stocks with less stringent repayment conditions and nationalizes passive restructuring banks, the regulator can attain the social optimal allocation by performing such a non-linear injection scheme under certain conditions.