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A Model of Optimal Corporate Bailouts

41 Pages Posted: 5 May 2011 Last revised: 5 May 2012

Antonio E. Bernardo

University of California, Los Angeles (UCLA) - Finance Area

Eric L. Talley

Columbia University - School of Law

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: May 10, 2011

Abstract

We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.

Keywords: Government Bailout, Moral Hazard, GM, Chrysler, TARP

JEL Classification: P16, P14, D72

Suggested Citation

Bernardo, Antonio E. and Talley, Eric L. and Welch, Ivo, A Model of Optimal Corporate Bailouts (May 10, 2011). Available at SSRN: https://ssrn.com/abstract=1830583 or http://dx.doi.org/10.2139/ssrn.1830583

Antonio E. Bernardo

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2198 (Phone)
310-206-5455 (Fax)

Eric L. Talley

Columbia University - School of Law ( email )

435 West 116th Street
New York, NY 10025
United States

HOME PAGE: http://www.erictalley.com

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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