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Monitoring, Bailouts, and Penalties: An Integrated Framework of Government Policies to Manage the Too Big to Fail Problem

36 Pages Posted: 24 Aug 2010 Last revised: 18 Oct 2013

Ning Gong

Deakin University; Financial Research Network (FIRN)

Kenneth D. Jones

State Street Corporation

Date Written: August 23, 2010

Abstract

This paper discusses optimal government bailout policy where the costs of systemic failures and moral hazard problems are considered. We find that a three-tiered bailout policy that includes an ex post monitoring and bailout scheme for institutions with large systemic impacts ('Too Big to Fail') is optimal. The optimal policy also requires a randomized bailout for medium-impact institutions ('Constructive Ambiguity'), and no bailout for firms that have only minimal systemic consequences ('Too Small to Save'). However, in a volatile, innovative market environment where individual institutions may know more than the government regulator, monitoring error could contribute to risk-taking, leaving the government regulator to always play a 'catch-up' role in revising policy. Moreover, the optimal bailout policy may not be time-consistent: institutions not deemed 'too big to fail' may still have an incentive to take excessive risks and expect to be bailed out in case of insolvency, primarily due to the short-term orientation of the government. Finally, because an institution’s systemic cost affects the probability of a bailout, we show that the boundary of a firm may be extended by the government subsidy.

Keywords: Bailout, Monitoring, Penalty, 'Too Big to Fail'

JEL Classification: E61, G01, G21

Suggested Citation

Gong, Ning and Jones, Kenneth D., Monitoring, Bailouts, and Penalties: An Integrated Framework of Government Policies to Manage the Too Big to Fail Problem (August 23, 2010). 23rd Australasian Finance and Banking Conference 2010 Paper. Available at SSRN: https://ssrn.com/abstract=1663619 or http://dx.doi.org/10.2139/ssrn.1663619

Ning Gong (Contact Author)

Deakin University ( email )

Department of Finance
Faculty of Business and Law
Burwood, Victoria 3125
Australia
+61 3 9246 8492 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Kenneth D. Jones

State Street Corporation ( email )

Boston, MA 02111
United States
617-662-0370 (Phone)

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