This paper theoretically analyzes how early corrective actions on troubled
banks affect bank risk-taking behavior. Early corrective actions considered in
this paper are classified into two categories: early closure and recapitalization.
Early closure might be preferable to save explicit costs(deposit insurance fund)
and suppress excessive risk-taking incentives, but there are implicit costs of
early closure. When the regulatory authority chooses early closure as the early
corrective action, banks take low risk level, which is, however, lower than
the first-best level. On the other hand, when recapitalization is chosen as a
corrective measure, the authority is able to induce banks to choose the
first-best risk level. And also recapitalization is preferable from the social
welfare point of view. Recapitalization gives better ex ante expected returns for
banks than early closure, so that there is Pareto improvement. The analysis of
this paper can be a theoretical explanation why recapitalization is more
frequently observed than early closure as corrective actions for troubled banks.