Optimal Timing in Banks' Write-Off Decisions under the Possible Implementation of a Subsidy Scheme: A Real Options Approach

This paper provides a formal model that investigates optimal timing in banks' writing off their nonperforming loans. The motivation comes from the recent episodes of Japanese banks, which have been slow to clean up their nonperforming loans after the collapse of the "bubble" economy in the early 1990s. A real options approach is employed to measure the value of the rationality of the "forbearance policy." It is assumed that uncertainty will arise from the following sources: (1) the reinvestment return from freeing up funds through write-offs; (2) liquidation losses; (3) the possible implementation of a subsidy scheme; and (4) the reputational repercussions from not immediately writing off their nonperforming loans. This paper attaches particular importance to the uncertainty from the possible implementation of the subsidy scheme to explore its desirable features. Also, this paper examines the possible role of monetary policy in boosting the banks' incentive to write off.