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Bailouts, the Incentive to Manage Risk, and Financial Crises

  • Stavros Panageas

A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away". I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality".

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15058.

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Date of creation: Jun 2009
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Publication status: published as S. Panageas ( 2010 ) “Bailouts, the incentive to manage risk, and financial crises”, Journal of Financial Economics , 95(3) , pp. 296 -­‐ 311
Handle: RePEc:nbr:nberwo:15058
Note: AP CF
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