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Bailouts, Contagion, and Bank Risk-Taking

  • LEV RATNOVSKI

    (International Monetary Fund)

  • Giovanni Dell'Ariccia

    (IMF)

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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File URL: https://economicdynamics.org/meetpapers/2012/paper_133.pdf
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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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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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