At the beginning of the past financial crisis sponsoring banks rescued their structured investment vehicles (SIVs) despite of lack of contractual obligation to do so. I show that this outcome may arise as the equilibrium of a signaling game between banks and their debt investors when a negative shock affects the correlated asset returns of a fraction of banks and their sponsored vehicles. The rescue is interpreted as a good signal and reduces the refinancing costs of the sponsoring bank. If banks’ leverage is high or the negative shock is sizable enough, the equilibrium is a pooling one in which all banks rescue. When the aggregate financial sector is close to insolvency, banks’ expected net worth would increase if rescues were banned. The model can be extended to discuss the circumstances in which all banks collapse after rescuing their vehicles.

We study restructuring solutions to the debt overhang problem faced by banks with a deteriorated loan portfolio in the presence of asymmetric information on loan quality. Classical liability restructuring solutions fail to work because banks can overstate the severity of their bad loan problem to obtain additional concessions from existing creditors. A sufficiently large loan sale requirement to the restructuring banks discourages such an opportunistic behavior, so a suitably chosen menu of loan sales cum liability restructuring is able to solve the debt overhang. We discuss the implementation of such a solution for banks funded with insured deposits through loan sales to outside investors supported by an asset protection scheme sponsored by the deposit insurance fund.

We study optimal government support following a rare disaster that creates heterogeneous firm liquidity needs. Firms’ increase in debt reduces their output due to moral hazard. Banks are subject to a minimum capital requirement that limits deposit insurance costs upon bad aggregate shocks. Without government support, firms’ moral hazard and banks’ funding frictions reinforce each other amplifying output losses. Optimal support is implemented with firm-specific transfers combined with the provision of aggregate risk insurance through a capital requirement relaxation and a public preferred equity stake in banks. Our results shed light on suboptimality features in the actual policy responses to Covid-19 lockdowns.

We quantify the gains from regulating maturity transformation in a model of banks that finance long-term assets with nontradable debt. Banks choose the amount and maturity of their debt by trading off investors’ preferences for short maturities with the risk of systemic crises. Pecuniary externalities make unregulated debt maturities inefficiently short. In calibrating the model to eurozone banking data for 2006, we find that lengthening the average maturity of wholesale debt from 2.8 to 3.3 months would produce welfare gains with a present value of euro 105 billion, while the lengthening induced by the NSFR would be too drastic. Received November 27, 2014; editorial decision November 14, 2016 by Editor Itay Goldstein.

We quantify the gains from regulating maturity transformation in a model of banks that finance long-term assets with nontradable debt. Banks choose the amount and maturity of their debt by trading off investors’preferences for short maturities with the risk of systemic crises. Pecuniary externalities make unregulated debt maturities inefficiently short. In calibrating the model to eurozone banking data for 2006, we find that lengthening the average maturity of wholesale debt from 2.8 to 3.3 months would produce welfare gains with a present value of euro 105 billion, while the lengthening induced by the NSFR would be too drastic.

Off-balance sheet financing of an investment is covered by limited liability, whereas on-balance sheet financing creates unlimited liability towards the bank’s asset-in-place. Off-balance sheet funding thus gives the bank flexibility to voluntarily support debt repayments when the investment fails, which allows the bank to signal information about the quality of its future projects, improving investment efficiency. Yet, limited liability reduces the bank’s effort incentives. Off-balance sheet funding with voluntary support is optimal for activities that are rapidly growing or negatively correlated with existing assets. The model yields testable predictions on the relationship between off-balance sheet debt spreads and sponsors’ characteristics.

We model the debt maturity choice of firms in the presence of fixed issuance costs in the primary market and search frictions in the secondary market for debt. In the secondary market, short maturities improve the bargaining position of sellers, which reduces the required issuance yield. Long maturities reduce reissuance costs. The optimally chosen maturity trades off both considerations. Equilibrium exhibits inefficiently short maturity choices. An individual firm does not internalize that a longer maturity increases expected gains from trade in the secondary market, which attracts more buyers and, hence, facilitates the sale of debt issued by other firms.

We analyze optimal cross-country risk sharing and bank capital requirements amid collective moral hazard by governments and banks. Transfers provide insurance but weaken fiscal discipline. Since lenient fiscal policies amplify banks’ risk-shifting, optimal support must be contingent on banking system health. For fiscally weak countries, support is larger in sovereign crises with solvent banks. For fiscally strong countries, support is larger in joint sovereign and bank crises, requiring deposit insurance mutualization. Optimal contracts feature lower capital requirements than without cross-country transfers, raising the cost of joint sovereign and bank crises to strengthen fiscal discipline and enable greater risk sharing.