Theories of soft budget constraints and the analysis of banking crises

Abstract

This paper proposes a new taxonomy for classifying models of soft budget constraints which allows identification of two classes of models. Distinguishing between these classes of models is useful, as they yield SBCs in differing circumstances and have differing theoretical and policy implications. The taxonomy is used to motivate an area of economic theory in which SBC models can yield novel insights: the analysis of banking crises. A model is presented in which SBCs arising from creditor passivity have implications for the question of the appropriate policy for dealing with bad debts on troubled banks' balance sheets. The paper also compares the implications of the two classes of SBC models for the analysis of banking crises.