Creditors are often passive because they are reluctant to show bad debts on their own balance sheets. In transition economies this problem is particularly severe. In this note, we analyze a simple general equilibrium model, which allows to study the externality effect of creditor passivity. The model yields rich insights in the phenomenon of creditor passivity, both in transition countries and developed market economies and allows to derive policy implications to solve creditor passivity. Our model explains in what respect banks are different from enterprises as creditors and what this implies for policy. Phenomenons that are commonly observed in banking, such as deposit insurance, government coordination to work out bad loans, and special bankruptcy proceedings for banks, are explained by this.
