Should We Commit to Bailing Out?

31 Pages Posted: 17 Feb 2012 Last revised: 26 Sep 2016

See all articles by James Dow

James Dow

London Business School - Institute of Finance and Accounting

Jungsuk Han

Seoul National University - College of Business Administration; Swedish House of Finance

Date Written: September 25, 2016

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

Suggested Citation

Dow, James and Han, Jungsuk, Should We Commit to Bailing Out? (September 25, 2016). Swedish House of Finance Research Paper No. 14-12, Available at SSRN: https://ssrn.com/abstract=2006464 or http://dx.doi.org/10.2139/ssrn.2006464

James Dow

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

Jungsuk Han (Contact Author)

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

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