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

27 Pages Posted: 3 Sep 2013

See all articles by Ning Gong

Ning Gong

Deakin University; Financial Research Network (FIRN)

Kenneth D. Jones

State Street Corporation

Date Written: September 2013

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 financial 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 institutions 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 an institution may be extended by the government subsidy.

Suggested Citation

Gong, Ning and Jones, Kenneth D., Bailouts, Monitoring, and Penalties: An Integrated Framework of Government Policies to Manage the Too‐Big‐To‐Fail Problem (September 2013). International Review of Finance, Vol. 13, Issue 3, pp. 299-325, 2013. Available at SSRN: https://ssrn.com/abstract=2319628 or http://dx.doi.org/10.1111/irfi.12011

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 )

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

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