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We thank Stijn Claessens, Martin Hellwig, Anjan Thakor, and the participants of SED meetings (Cyprus), FDIC Annual Bank Research Conference, Workshop on International Economics and Finance at CREI (Barcelona), SUERF meetings (Zurich), UC Davis Symposium on Financial Institutions and Financial Stability, and seminars at IMF and Max Planck Institute for Collective Goods (Bonn) for helpful comments.
While we focus on the risk that a bank failure imposes on other banks, other papers have focused on the potential benefits for competing banks that can buy assets of a distressed institution at firesale prices, possibly with government support to the buyer (Perotti and Suarez, 2002, Acharya and Yorulmazer, 2008a).
Orszag and Stiglitz (2002) use the creation of fire departments as a parable to describe how risk taking incentives are affected by externalities and public policy. In their model (like here), individuals do not take into account the effects of fireproof houses on reducing the risk of fire damage to their neighbors’ homes, and invest too little in fire safety. The introduction of a fire department reduces the risk of a fire, but further worsens individual incentives, as it reduces the probability that a fire spreads from one house to another. To extend their parable, our paper is more about condo buildings rather than single-family houses. If the rest of the building burns down and collapses, a condo owner gets little benefit from having fireproofed her own apartment. Then, the introduction of a fire department makes individual safety measures more valuable as it reduces the probability of total meltdown.
Also, some interbank exposures may be economically beneficial because they provide market discipline (Rochet and Tiróle, 1996).
Bailouts can leave rents to bank managers and creditors too, in which case they increase also their risk taking incentives. Our stylized model abstracts from effects on bank managers and creditors.
In the absence of deposit insurance, the deposit rate would be risk-sensitive and reflect depositors’ expectations on bank solvency. This would strengthen our results on the “systemic insurance” effect of bailouts. The promise of a bailout would reduce the deposit rate and increase bank profits in case of success, which would make the positive effects of bailouts on bank monitoring larger.
The fact that θ can take values between 0 and 1 captures the notion that the government’s exact reaction function may not be public knowledge, or more likely that it is not certain that, even in the case of intervention, default and contagion can be avoided.
Note that here we assume that government needs to intervene before observing whether a failure is actually contagious. Under a “more efficient” bailout policy of only intervening after contagion is observed were available, our results would still hold. Moreover, such policy would reduce moral hazard and tilt the balance more in favor of the “insurance” effect.
In practice, it may be that the probability of contagion increases with the correlation of idiosyncratic risks. For instance, contagion may be stronger when banks invest in the same or similar sectors, but do not achieve the full correlation of returns, so as to make contagion risk irrelevant. By focusing on full correlation, our model abstracts from this issue. If we were to introduce this effect, the results in this section would depend on the functional form of the relationship between the correlation of idiosyncratic risks with the risk of contagion.
This can result from funding more marginal projects and from compressed margins due to increased competition for the same borrowers. For our analysis the two sources of decreased profitability are equivalent. From an aggregate welfare standpoint, however, the first would be a net loss, while the second would be just a transfer and may actually be welfare improving if it reduces oligopolistic rents.