Working Paper: CEPR ID: DP10560
Authors: Franklin Allen; Elena Carletti; Itay Goldstein; Agnese Leonello
Abstract: Government guarantees to financial institutions are intended to reduce the likelihood of runs and bank failures, but are also usually associated with distortions in banks? risk taking decisions. We build a model to analyze these trade-offs based on the global-games literature and its application to bank runs. We derive several results, some of which against common wisdom. First, guarantees reduce the probability of a run, taking as given the amount of bank risk taking, but lead banks to take more risk, which in turn might lead to an increase in the probability of a run. Second, guarantees against fundamental-based failures and panic-based runs may lead to more efficiency than guarantees against panic-based runs alone. Finally, there are cases where following the introduction of guarantees banks take less risk than would be optimal.
Keywords: bank; moral hazard; fundamental runs; government guarantees; panic runs
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government guarantees (H81) | Probability of bank runs (E44) |
| Government guarantees (H81) | Risk-taking behavior of banks (G21) |
| Risk-taking behavior of banks (G21) | Probability of runs due to fundamental failures (C41) |
| Government guarantees (H81) | Effects on panic-based and fundamental-based runs (E44) |
| Guarantee scheme protecting against both types of runs (E44) | Efficiency of financial system (P43) |