This paper introduces two methods of hiding loan losses and analyzes how they affect a bank's loan interest income, payments on deposits, liquidity and moral hazard. The analysis reveals that a hiding method represents a Ponzi scheme. Contrary to classic theory, e.g. Diamond (1984), moral hazard may arise even though a bank's loan portfolio is diversified. Alternative instruments to eliminate hiding are investigated. Under specific circumstances, a Ponzi scheme may provide a socially optimal method to create liquidity and prevent a failure of a solvent but illiquid bank.

In the dynamic model of banking, a bank's option to hide its loan losses by rolling over non-performing loans is shown to worsen moral hazard. Contrary to the classic theory, moral hazard may arise even when a bank cannot seek a correlated risk for its loans. The loans seem to be performing and the bank makes a profit although it is de facto insolvent. When the bank's balance sheet includes hidden non-performing loans, the bank may optimally shrink lending or gamble for resurrection by growing aggressively. To eliminate this type of moral hazard, which is broadly consistent with evidence from emerging economies, a few regulatory implications are suggested.

This paper explores costs and proceeds from loan collateral in the credit market with ex-ante asymmetric information when collateral value and the probability of project success fluctuate. A borrower is willing to pledge collateral if (i) its future value is correlated with the probability of project success, or (ii) its value fluctuates strongly, or (iii) it is funded with loan capital. When one of the conditions is satisfied, in contrast to Bester (1985), a high-risk borrower may be more willing to pledge collateral than a low-risk borrower. The paper is related to topical subprime crises and real estate collateral.

This paper presents two models in which the fluctuating value of loan collateral (real estate) generates the problem of moral hazard between a bank and a deposit insurance agent. The bank finances risky projects against collateral and relies on the rising collateral value. If the collateral value later appreciates, the bank enjoys handsome profits; otherwise, the bank fails. The findings are rather consistent with the characteristics of the topical subprime mortgage crisis.

This paper examines the incentive problem between a bank and depositors (or deposit insurer): limited liability makes risk-shifting lucrative. We show how intertemporal diversification of lending decisions – i.e. bank’s loan portfolio consists of overlapping long-term loans and is thus gradually renewed – may solve the incentive problem of risk-shifting. A new (or expanding) bank sets a high-equity level and acquires depositors’ confidence. Subsequently, it can allow its equity to depreciate to a permanently lower level. Depositors can control the bank by monitoring equity and realized credit losses ex post; they do not have to monitor bank’s lending choices ex ante. Maturity mismatch – illiquidity of long-term loans and liquidity of deposits – is optimal. The analysis can be extended more generally to the borrower–lender relationship.

This paper examines blanket guarantee, deposit insurance and restructuring decisions with respect to a multinational bank (MNB) using Nash bargaining when the threat of a bank panic motivates countries to make decisions quickly. Failure of the bank would unevenly distribute externalities across countries, influencing the restructuring incentives. In equilibrium, the bank is either liquidated or one of the countries – or both – recapitalizes it. A partition of the recapitalization costs is sensitive to the country-specific benefits and costs from recapitalization, panic and liquidation. The home regulator benefits from the advantage that it is the only entity that can legally liquidate the MNB. Rational expectations regarding the bargaining result affect the incentives to declare a blanket guarantee.