Catharsis—The real effects of bank insolvency and resolution

• We analyze the impact of orderly bank insolvency resolution on the real economy.
• We propose a new ‘catharsis’ indicator to measure how orderly banks are resolved.
• ‘Catharsis’ has a positive and significant effect on individual firm growth.
• The effect is stronger for firms that are structurally more dependent on banks.
• The ‘catharsis effect’ works best in open banking systems.

This paper analyzes the impact of rules-based bank insolvency resolution on real economic growth. Resolving insolvent banks can positively affect the real economy by overcoming moral hazard problems and improving banks’ credit allocation and monitoring. We propose a new indicator to measure the strength of ‘catharsis’, i.e., how strictly banks are resolved, and use a large firm-level dataset to test its effect. We find that a relatively stronger implementation of bank resolution rules has a statistically and economically significant positive effect on firm growth – particularly with respect to firms that are structurally more dependent on bank financing. Our findings are robust to various specifications. Investigating the transmission channels of this ‘catharsis effect’ reveals that it essentially works by means of benefiting higher quality firms (quality channel) and reallocating credit to firms that need it most (quantity channel). Additional analysis suggests that the ‘catharsis effect’ works best in banking systems that offer access to international financing because such access mitigates the potentially negative credit supply effects of liquidating insolvent banks. Taken together, our findings indicate that more attention should be focused on developing incentive-compatible bank resolution regimes.