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

50 Pages Posted: 12 May 2023

See all articles by Wolf Wagner

Wolf Wagner

Erasmus University Rotterdam (EUR)

Jing Zeng

University of Bonn; Centre for Economic Policy Research (CEPR)

Date Written: May 2, 2023

Abstract

We analyze the design of bailout regimes when investment is distorted by a too-many-to-fail problem. The first-best allocation equalizes benefits from more banks investing in high-return projects with endogenously higher systemic risk due to more banks failing simultaneously. A standard bailout policy cannot implement the first-best, as bailouts cause herding by banks.

However, a targeted bailout policy that assigns banks to separate bailout regimes eliminates herding and achieves the first-best. When such a policy is not feasible, targeted bailouts can be implemented by decentralizing bailout decisions to independent regulators. Our results have various implications for the optimal allocation of regulatory powers, both at the international level and domestically.

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

JEL Classification: G1, G2

Suggested Citation

Wagner, Wolf and Zeng, Jing, Too-Many-To-Fail and the Design of Bailout Regimes (May 2, 2023). Available at SSRN: https://ssrn.com/abstract=4435111 or http://dx.doi.org/10.2139/ssrn.4435111

Wolf Wagner

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Jing Zeng (Contact Author)

University of Bonn ( email )

Adenauerallee 24-26
Bonn, D-53012
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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