Systematic Risk, Bank Moral Hazard, and Bailouts

29 Pages Posted: 3 Apr 2018

See all articles by Marcella Lucchetta

Marcella Lucchetta

Ca Foscari University of Venice

Michele Moretto

University of Padua, Dep of Economics and Management

Bruno Maria Parigi

University of Padova - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 3 versions of this paper

Date Written: January 2018

Abstract

We show that the impact of government bailouts (liquidity injections) on a representative bank’s risk taking depends on the level of systematic risk of its loans portfolio. In a model where bank’s output follows a geometric Brownian motion and the government guarantees bank’s liabilities, we show first that more generous bailouts may or may not induce banks to take on more risk depending on the level of systematic risk; if systematic risk is high (low), a more generous bailout decreases (increases) bank’s risk taking. Second, the optimal liquidity policy itself depends on systematic risk. Third, the relationship between bailouts and bank’s risk taking is not monotonic. When systematic risk is low, the optimal liquidity policy is loose and more generous bailouts induce banks to take on more risk. If systematic risk is high and the optimal liquidity policy is tight, less generous bailouts induce banks to take on less risk. However, when high systematic risk makes a very tight liquidity policy optimal, a less generous bailout could increase bank’s risk taking. While in this model there is only one representative bank, in an economy with many banks, a higher level of systematic risk could also be a source of systemic risk if a tighter liquidity policy induces correlated risk taking choices by banks.

Keywords: bailout, bank closure, real option, systematic risk

JEL Classification: G00, G20, G21

Suggested Citation

Lucchetta, Marcella and Moretto, Michele and Parigi, Bruno Maria, Systematic Risk, Bank Moral Hazard, and Bailouts (January 2018). CESifo Working Paper Series No. 6878, Available at SSRN: https://ssrn.com/abstract=3155085

Marcella Lucchetta

Ca Foscari University of Venice ( email )

Venice
Italy

Michele Moretto

University of Padua, Dep of Economics and Management ( email )

via Del Santo 33
Padova, 35123
Italy
+39 049 8274265 (Phone)
+39 049 8274211 (Fax)

Bruno Maria Parigi (Contact Author)

University of Padova - Department of Economics ( email )

via Del Santo 33
Padova, 35123
Italy

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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