The paper develops a theoretical model to analyze optimal intervention policies to address banks' legacy problems. A low recovery rate on non-performing loans may create a cost for the Deposit Guarantee Scheme should the bank fail and may reduce the bank’s capitalization, with possible negative effects on new credit.
The optimal policy consists of a required disposal of a fraction of the non-performing loans, followed by some subsidy from the Deposit Guarantee Scheme. The non-performing loan disposal induces the concession of new credit, whose payoff lowers the bank's default probability and the cost for the Deposit Guarantee Scheme, while the subsidy reduces the bank’s losses. The optimal value of the subsidy is just enough to avoid the bank's liquidation.
