Should We Commit to Bailing Out?

Abstract

A commitment to an ex-post inefficient bailout can be ex-ante optimal because it can mitigate rollover problems without an actual bailout. Reinforcement between illiquidity and insolvency create beneficial multiplier effects that overwhelm the adverse effect of moral hazard. Committing to bail out using a rescue fund can be more effective and cheaper than directly injecting liquidity because of the option value of not exercising the rescue later if the economy ends up in a good state. The paper concerns a public agency that bails out a government of a distressed country, but the results can be applied, with minor modifications, to domestic banking crises.

Keywords: rescue fund; bailout; commitment; financial distress; multiplier effect

JEL Classification: F34, G01, G21, G28, H63