In Defense of Bailouts

Abstract:     
Systemic risk - the possibility that an individual firm’s failure will result in broad damages to the economy as a whole - is the epitome of financial crisis. Bailouts of troubled firms have long been the standard response to systemic risk. Yet, bailouts suffer from problems of political legitimacy.

Bankruptcy is often presented as more legitimate alternative to bailouts because its loss allocation system is preset and determined in the abstract. This Article argues that the choice between bailouts and bankruptcy is illusory. Bailouts and bankruptcy are not alternative choices, but an integrated system; any preset resolution system will be abandoned for a bailout if it would produce socially unacceptable loss allocations. Therefore, bailouts’ political legitimacy is critical.

Accordingly, the Article proposes a framework for analyzing bailouts’ legitimacy. It identifies and explores two fundamental questions involved in all bailouts. First, should bailouts be done ad hoc through Congress or should bailout authority be institutionalized in an agency? And second, should creditors of bailed out firms be forced to accept less than full payment (or take a “haircut”) as part of the bailout? Ensuring accountability and fairness in resolving these issues is essential for bailouts’ political legitimacy and ultimate efficacy.

Number of Pages in PDF File: 80

Keywords: bailout, systemic risk, contagion, common shock, resolution authority, living will, bankruptcy, haircut, GM, AIG

JEL Classification: G28, G20, G33, K20, K23

Accepted Paper Series