Efficient Bailouts?

By Javier Bianchi

http://d.repec.org/n?u=RePEc:fip:fedmwp:730&r=dge

We develop a quantitative equilibrium model of financial crises to assess the interaction between ex-post interventions in credit markets and the buildup of risk ex ante. During a systemic crisis, bailouts relax balance sheet constraints and mitigate the severity of the recession. Ex ante, the anticipation of such bailouts leads to an increase in risk-taking, making the economy more vulnerable to a financial crisis. We find that moral hazard effects are limited if bailouts are systemic and broad-based. If bailouts are idiosyncratic and targeted, however, this makes the economy significantly more exposed to financial crises.

This is a controversial and unfortunately too politicized subject: Is bailing out banks go or bad. As so often, the answer is “it depends.” Here, it depends on the type of bailout. Helping out an individual bank is more hurtful than helping them all. This is the result of the fact that systemic crises are much rarer than individual ones, and the the systemic crises influence little behavior. Individual crises are a direct consequence of bank choices, thus any targeted bailout will influence them.

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