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Economic Quarterly

Winter 2004

Closing Troubled Banks: How the Process Works

John R. Walter

To minimize their losses, creditors of insolvent nonbank firms have every incentive to force prompt closure, thereby ensuring that assets of such firms are redirected to more valuable uses. For banks and savings institutions, however, deposit insurance blunts the incentive by removing depositors’ exposure to losses. Since bank creditors have little reason to require prompt closure, the responsibility is left to bank supervisors. Policies of the Federal Deposit Insurance Corporation Improvement Act of 1991 guide the performance of this vital responsibility. Originally intended to mend weaknesses that became apparent during the widespread S&L failures of the 1980s, the Act moved the supervisory process for banks closer to the market's solution for nonbank firms. Still, under some circumstances, policies veer from the market solution.

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