Do Bailouts Cause Moral Hazards or Franchise Value in Banking?

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Summary Governmental safety nets are said to be a major source of moral hazard in banking. If profits are private but losses are borne by taxpayers, banks have perverted incentives to take excessive risks. Cordella and Levy Yeyati (2003) presented an opposing hypothesis. Safety nets offered during turbulent times help banks to survive and may increase banks' franchise value. This induces stronger risk aversion. This unorthodox hypothesis is tested with a cross-national comparison. National banking crises in 1981–2003 were handled by national authorities in different ways, and countries may have built reputations as tough or generous crisis managers. The recent financial crisis was less severe in countries where the government had offered blanket guarantees in previous crises, which may be interpreted as a sign of stronger risk aversion during the pre-2007 build-up phase. Moreover, losses suffered by depositors in past crises made the recent crisis worse. These findings are consistent with the franchise value hypothesis but in strict contradiction with the mainstream moral hazard argumentation. The finding is politically unpopular and based on relatively few observations, but it is statistically significant and robust to the inclusion of numerous control variables.