Too-Many-To-Fail and the Design of Bailout Regimes

Abstract

We show that the too-many-to-fail problem can be resolved through an appropriate design of the bailout-regime. In our model, optimal investment balances benefits from more banks investing in high-return projects against higher systemic costs due to more banks failing simultaneously. Under a standard bailout regime, banks herd, anticipating that simultaneous failures trigger bailouts. However, a policy that prioritizes bailing out a predesignated group of banks eliminates herding and achieves the first-best. If such a policy is not feasible, its benefits can be attained by decentralizing bailout decisions to two regulators each responsible for a separate group of banks.

Keywords: systemic risk, too-many-to-fail, optimal investment, bailouts

JEL Classification: G1, G2