- Bank Bailouts: Cost of Inability to Commit (Job Market Paper)
Abstract: I develop a theoretical model to investigate the failure to commit in the provision of bailouts to financial institutions. When financial institutions fail, the fiscal authority often deviates from the ex-ante no-bailout commitment as the ex-post best response is bailout. The fiscal authority’s time inconsistency creates moral hazard. I analyze the welfare loss from the failure to commit. In the model, as long as the fiscal authority is able to commit to a pre-determined bailout policy, the outcome is typically constrained efficient. Furthermore, a higher probability of bank run is not always welfare reducing. Increased run probability can be beneficial by making financial institutions more cautious, thus decreasing moral hazard loss. Regulations on short-term interest rates offered by financial institutions can also effectively deter moral hazard, particularly when the run probability is small.
Abstract: This paper analyzes the optimal bailout policy in an interconnected banking system. This model allows banks to deposit in each other to hedge against idiosyncratic liquidity shocks. When a fraction of banks in the economy are hit by a liquidity shock and become insolvent, there are potential spillovers to solvent banks. In this case, the optimal bailout policy is not always either a full bailout or zero bailout. It is sometimes optimal for the fiscal authority to provide partial bailouts that are just sufficient to prevent the spillovers. The decision of the fiscal authority depends on how much pressure it receives from taxpayers and banks. If the urgency to save the banking sector outweighs the utility from public goods, a full bailout is optimal, and vice versa. When the two effects are comparable, the optimal decision of the fiscal authority is partial bailout.
Works in Progress:
- The Bailout Incentive on Excessive Risk-taking Behavior in Banks