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We are grateful to Giovanni Dell’ Ariccia, Gianni De Nicolo, Curzio Giannini, Haizhou Huang, Robert Marquez and participants at the IMF and at the Federal Reserve Board of Governor research workshops for their helpful comments and suggestions. Also, we thank Natalie Baumer for editorial assistance.
Universidad Torcuato di Tella, Buenos Aires, Argentina.
Harris and Raviv (1979) prove indeed that the problem of moral hazard can be avoided when agents are risk neutral.
Also, as Innes recognizes, if enterpreneurs (banks in our framework) have access to short-term borrowing, they would have incentives to inflate their profits to increase the reward.
The stochastic structure of the model is that of Blum (1999), to which we add a random state of nature limiting the bank’s control over risk.
We implicitly assume that existing or prospective shareholders can indeed provide the needed funds, thus abstracting from cases in which liquidity constrained capital markets fail to rescue illiquid but solvent institutions.
Alternatively, we could assume that the deposit insurance fund fully guarantees the repayment of deposits, while the monetary authority simply allows an insolvent bank to keep its license.
It is straightforward to verify that
We thank Giovanni Dell’Ariccia for suggesting this formulation of the necessary condition.
This applies, of course, to the particular case of a blanket guarantee such that β(γ) = 1, for all γ.
The negative link between financing costs and discount rates, on the one side, and the choice of risk, on the other, is a natural implication of our basic model and does not depend on the existence of a bailout policy. In particular, it suggests that countries with higher costs of capital are more prone to engaging in excessive risk.
It is easy to verify this by applying the implicit function theorem to (28), from which we have that
A lower threshold implies a lower value of C which, under the non-default scenario, leads to lower equilibrium risk.
It is straightforward to show that the following argument holds when deposits are partially insured.
The argument applies irrespective of whether the bailed out bank’s liabilities are assumed by the deposit insurance fund or are paid for by bailout money provided directly to the bank by the central bank.
Examples include negative real shocks depressing the level of economic activity, sudden changes in country risk that push up domestic interest rates, or sharp devaluations that increases the risk of default on foreign currency loans to producers of non-tradables.
These extensions will be discussed in detail in a future companion paper.