On 1st February 2019 we have Khai Zhi Sim of Cornell University visiting us. He is going to give a seminar titled Bank Bailouts: Cost of Inability to Commit at 12:15-13:30 in room A406 in Building Q, Budapest University of Technology and Economics, Faculty of Economic and Social Sciences, Magyar tudósok körútja 2, 1117 Budapest. Sandwiches will be provided. Please register.
Abstract: I develop a theoretical model to investigate the failure to commit in the provision of bailouts to financial institutions. When financial institutions fail, the fiscal authority often deviates from the ex-ante no-bailout commitment as the ex-post best response is bailout. The fiscal authority’s time inconsistency creates moral hazard. I analyze the welfare loss from the failure to commit. In the model, as long as the fiscal authority is able to commit to a pre-determined bailout policy, the outcome is typically constrained efficient. Furthermore, a higher probability of bank run is not always welfare reducing. Increased run probability can be beneficial by making financial institutions more cautious, thus decreasing moral hazard loss. Regulations on short-term interest rates offered by financial institutions can also effectively deter moral hazard, particularly when the run probability is small.