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Authors: Giovanni Dell'Ariccia and Lev Ratnovski
The reason is that bailouts protect banks against contagion, removing an exogenous source of risk, and this may increase bank incentives to monitor loans. The interaction between the moral hazard and systemic insurance effects of expected bailouts is the focus of this paper.
While banks have some control over direct exposures, the indirect links are largely beyond an individual bank's control. The threat of contagion affects bank incentives. The key mechanism considered in this paper is that when a bank can fail due to exogenous circumstances, it does not invest as much to protect itself from idiosyncratic risk... Moreover, making the threat of contagion endogenous to the risk choices of all banks generates a strategic complementarity that amplifies initial results: banks take more risk when other banks take more risk, because risk taking of other banks increases the threat of contagion.
Conclusion
It is accepted that bailouts have a moral hazard effect that encourages risk-taking. However this paper also shows that when there are risk externalities across banks, this effect coexists with an opposite one: bailouts protect prudent banks against contagion. This encourages monitoring and reduces bank risk taking. On net, a government's commitment to save systemic banks when the threat of contagion is high may reduce risk taking by all banks even when bailouts leave banks some (modest) rents.
The model is open to extensions and interpretations. One could rewrite the model in the context of banks' short-termist behaviour that was prevalent in the run-up to the recent crisis. Indeed, the concept of "insufficient monitoring" can be interpreted as business practices that generate short-term return at expense of higher long-term risk: fee- and volume-based banking, lending with teaser rates, or the use of cheaper but unstable short-term funding. This analysis shows that banks will have more incentives to engage in short-termist strategies when they are exposed to contagion risk that affects their long-term returns, especially if other banks are also engaging in such strategies...
The results in this paper offer policy implications relevant to the current bank resolution and crisis management debates. In particular, the results caution that the recent initiatives that create impediments to timely and targeted intervention may in effect destabilise the financial system. First, they would make the financial system more unstable in the run-up to and during crises, when banks would respond to the risk of contagion by neglecting monitoring and/or by correlating risk with unstable banks. Second, reducing scope for timely, targeted interventions may leave governments with no ex-post options but to undertake more macro, less targeted bailouts, which leave greater rents to failing banks and hence are more distortive. The model suggests that a more promising policy direction is to focus on the efficiency of interventions: creating legal and practical conditions where interventions in distressed banks can be undertaken easily but effectively: leaving bank shareholders (and other stakeholders) as little rents as possible.