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Bailouts, Contagion, and Bank Risk-Taking

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  • LEV RATNOVSKI

    (International Monetary Fund)

  • Giovanni Dell'Ariccia

    (IMF)

Abstract

We revisit the link between bailouts and bank risk taking. The expectation of government support to failing banks (bailout) creates moral hazard and encourages risk-taking. However, when a bank's success depends on both its idiosyncratic risk and the overall stability of the banking system, a government's commitment to shield banks from contagion may increase their incentives to invest prudently. We explore these issues in a simple model of financial intermediation where a bank's survival depends on another bank's success. We show that the positive effect from systemic insurance dominates the classical moral hazard effect when the risk of contagion is high.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 133.

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Date of creation: 2012
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Handle: RePEc:red:sed012:133

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
  2. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  3. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises," IMF Working Papers 08/224, International Monetary Fund.
  4. Perotti, Enrico C & Suarez, Javier, 2001. "Last Bank Standing: What Do I Gain if You Fail?," CEPR Discussion Papers 2933, C.E.P.R. Discussion Papers.
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