Abstract

This paper develops a simple model of the gap between socially and privately optimal bank lending when a bank has an overhang of impaired loans, and analyzes government policies designed to close this gap. The impaired loans have risky cash fows but observable market values. A number of basic concepts are explicated including the risky lending gap, the capital component and asset risk component of the risky lending gap, capital injections versus asset purchases as policy tools, decomposition of the e¤ects of asset purchases into loan substitution and risk absorption e¤ects, the supply schedule of risky lending, the no-lending trap, and a risk-capital metric for comparing the various policy choices. The model is calibrated to match the cur- rent Irish banking environment and some tentative policy implications are suggested.