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Bailouts and Systemic Insurance

Bailouts and Systemic Insurance by Giovanni Dell'Ariccia
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We revisit the link between bailouts and bank risk taking. The expectation of government support to failing banks creates moral hazard—increases bank risk taking. However, when a bank's success depends on both its effort and the overall stability of the banking system, a government's commitment to shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking. This systemic insurance effect will be relatively more important when bailout rents are low and the risk of contagion (upon a bank failure) is high. The optimal policy may then be not to try to avoid bailouts, but to make them “effective”: associated with lower rents.
International Monetary Fund; November 2013
28 pages; ISBN 9781475519631
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Title: Bailouts and Systemic Insurance
Author: Giovanni Dell'Ariccia; Lev Ratnovski