Banks Without Parachutes: Competitive Effects of Government Bail-Out Policies

We analyze the competitive effects of government bail-out policies in two models with different degrees of transparency in the banking sector. Our main result is that bail-outs lead to higher risk-taking among the protected bank’s competitors, independently of transparency. The reason is that the prospect of a bail-out induces the protected bank to expand, which intensifies competition in the deposit market, depresses other banks’ margins, and thereby increases risk-taking incentives. Contrary to conventional wisdom, protected banks may take lower risks when transparency in the banking sector is low and the deposit supply is sufficiently elastic.

Hendric Hakens and ISabel Schnabel

Journal of Financial Stability

September 2010

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