This paper explores the joint effect of aggregate productivity shocks and capital market liberalization on the optimal bailout (or liquidation) policy of banks towards defaulted borrowers. It suggests that in bad times both good and bad firms default on their obligations, it is harder for the bank to distinguish between the two and therefore it is less costly to bail out defaulted firms. Therefore, the optimal liquidation rate in a closed economy may be substantially lower in recessions than in booms. In an economy with open capital markets, however, the corporate rate of return has to be raised at least up to the world rate of interest by improving the composition of the corporate sector through higher liquidation in order to prevent an outflow of capital and the subsequent financial crisis. As a result, the optimal liquidation rate (bailout rate) during recessions may be much higher (lower) in an economy with liberalized capital markets than in a closed economy. The model in this paper explains why liquidation rates of defaulted firms have risen significantly and structural reform to facilitate more liquidation has been pursued after the financial crisis in those East Asian countries with more liberalized capital markets.

Executive Summary

I. Introduction

II. Basic Model
1. Aggregate productivity shock
2. Firms
3. The bank and the financial contract

III. Bailout in a Closed Economy
1. Optimal Bailout Policy
2. Impac of the Aggregate Shock

IV. Optimal Bailout in a Small Open Economy
1. Open Economy and Capital Outflows
2. Optimal Bailout in an Open Economy

V. Conclusion

References