Creditors are often passive because they are reluctant to show bad debts on their own balance sheets. We propose a simple general equilibrium model to study the externality effect of creditor passivity. The model yields rich insights in the phenomenon of creditor passivity, both in transition and developed market economies. Policy implications are deduced. The model also explains in what respect banks differ from enterprises and what this implies for policy. Commonly observed phenomenons in the banking sector, such as deposit insurance, lender of last resort facilities, government coordination to work out bad loans and special bank closure provisions, are interpreted in our framework.