Excessive Lending, Leverage, and Risk-Taking in the Presence of Bailout Expectations

IMF Working Papers, October 1, 2009

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Canonical URL: Excessive Lending, Leverage, and Risk-Taking in the Presence of Bailout Expectations

Author: Andréas Georgiou
Date: October 1, 2009
Core finding: Rational economic agents engage in ex ante excessive lending, borrowing, and risk-taking if creditors assign a positive probability to being bailed out.
Context: The financial crisis that began in 2007 highlighted excesses in lending, leverage, and risk-taking as fundamental causes of the crisis and coincided with large scale government interventions often referred to as bailouts of lenders.
Recommended long-run approach: It would be most productive if lending institutions were not bailed out; if the continuing existence of an institution is deemed essential, assistance should take the form of capital injections that dilute the equity of existing owners.

Framework: Presents a model where expectations of bailouts alter creditor and borrower incentives, leading to ex ante excessive lending, borrowing, and risk-taking.
Mechanism: Positive probability assigned by creditors to future bailouts reduces the private cost of risk-taking and leverage, encouraging larger exposures and moral hazard.
Empirical/analytical emphasis: Focus on the role of bailout expectations in generating systemic risk through altered incentives.

Primary policy recommendation: Avoid bailing out lending institutions to mitigate incentives for excessive risk-taking.
Conditional assistance recommendation: If an institution's continued existence is essential, provide assistance in the form of capital injections that dilute existing owners’ equity.
Rationale: Dilution through capital injections aligns incentives by imposing losses on existing owners and reduces moral hazard compared with blanket bailouts.