Bailouts and Systemic Insurance

IMF Working Papers, November 12, 2013

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The expectation of government support to failing banks creates moral hazard—increases bank risk taking.
When a bank’s success depends on both its effort and the overall stability of the banking system, a government’s commitment to shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking.
The systemic insurance effect will be relatively more important when bailout rents are low and the risk of contagion (upon a bank failure) is high.
The optimal policy may then be not to try to avoid bailouts, but to make them “effective”: associated with lower rents.

Recognize the trade-off between moral hazard from bailout expectations and systemic insurance benefits from commitments to limit contagion.
Where contagion risk is high and bailout rents are low, policymakers may prefer making bailouts effective (linked to lower rents) rather than strictly avoiding bailouts.
Design resolution and support frameworks to minimize rents extracted by banks while preserving systemic insurance benefits.

Reexamines link between bailouts and bank risk taking.
Focuses on interactions among bank effort, bank portfolio choice, and overall banking system stability.
Addresses moral hazard, systemic risk, contagion, bank monitoring, bank resolution, and related financial sector policy concerns.