Credit Insurance, Bailout And Systemic Risk

This paper studies the impact of the expectation of bailout of a systemically important credit insurance firm, like AIG, on the ex-ante investment strategies of the counterparty banks. Failure of the insurance firm may result in subsequent failure of both solvent and insolvent counterparty banks by triggering a run on them. As during the run, the regulator cannot distinguish between solvent and insolvent banks, hence it cannot use targeted policies to bailout the system, such as providing liquidity to the solvent banks to buy the insolvent ones. So the regulator has to bailout the insurance firm. This imperfectly targeted policy incentivizes the banks to make correlated in-vestments ex ante and thus create systemic risk. I build a model in which correlated investment by banks, under-priced insurance contracts and a systemically important insurance firm arise endogenously. I further show that the insurance firm instead of diversifying its risk, chooses to invest in the same industry as the banks thereby in-creasing the size of the bailout. The policy implication is that putting a limit on the size of insurance firm can mitigate the problem of creation of systemic risk and thus prevent bailouts.