Bailouts and systemic insurance

Abstract

Abstract We revisit the link between bailouts and bank risk taking. Bailout expectations create moral hazard – increase bank risk taking. However, when an individual bank’s success depends on both its effort and the overall stability of the banking system, bailouts that shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking. This systemic insurance effect is more important when bailout rents are low while contagion risk is high. The optimal policy is then to make bailouts not difficult, but “effective” : associated with lower rents. We further show that, besides better bank resolution, a powerful means to reduce bailout rents is higher ex ante bank capital, since it implies a larger bank equity cushion that can be expropriated in a resolution. This highlights an important complementarity between bank capital regulation and bailouts as tools to enhance financial stability.