Bank bailouts: Moral hazard and commitment

Abstract

This paper investigates moral hazard from bank bailouts and its welfare implications. The traditional channel of moral hazard in existing literature arises from banks offering excessively attractive deposit contracts that lead to inefficiently large bailouts when there is a run. This paper introduces a new, second channel of moral hazard: bailouts discourage banks from offering deposit contracts that deter panic-based runs. It also identifies when the second channel is active, and decomposes the welfare losses contributed by the two channels. Whenever the second channel is active, commitment on the bailout policy alone is unable to fully eliminate the welfare loss from moral hazard. Alternative regulations such as controlling short-term interest rates offered by banks are necessary to achieve efficiency. Additionally, the second channel can cause welfare to be increasing with the probability of bank runs. The increased run probability helps encourage banks to offer run-proof contracts, easing the necessary effort from the fiscal authority to intervene.