Systematic Risk, Bank Moral Hazard, and Bailouts
26 Pages Posted: 13 Nov 2017 Last revised: 28 Nov 2017
Date Written: November 27, 2017
This paper studies the relationship between government bailouts and bank risk taking. We show that the impact of government bailouts (in the form of liquidity injections) on bank risk taking, depends on the exogenous level of systematic risk. In a model where the output follows a geometric Brownian motion and the government guarantees the bank liabilities, we find that: 1) per se more generous bailouts may or may not induce banks to take on more risk depending on systematic risk; in particular if the systematic risk is high (low), a more generous bailout decreases (increases) bank risk taking; 2) the optimal liquidity policy itself depends on systematic risk; 3) When systematic risk is taken into consideration, the relationship between bailouts and bank risk taking is positive, for low systematic risk and when high systematic risk induces tight liquidity policy, and could be negative when high systematic risk induces a very tight liquidity policy, which, in turn, could induce high risk taking.
Keywords: bank closure, real option, systematic risk
JEL Classification: G01, G2
Suggested Citation: Suggested Citation