Working Paper: NBER ID: w28412
Authors: Sewon Hur; Csar Sosapadilla; Zeynep Yom
Abstract: We study optimal bailout policies amidst banking and sovereign crises. Our model features sovereign borrowing with limited commitment, where domestic banks hold government debt and extend credit to the private sector. Bank capital shocks can trigger banking crises, prompting the government to consider extending guarantees over bank assets. This poses a trade-off: Larger bailouts relax financial frictions and increase output, but increase fiscal needs and default risk (creating a ‘diabolic loop’). Optimal bailouts exhibit clear properties. The fraction of banking losses the bailouts cover is (i) decreasing in government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of banking crises. Even though bailouts mitigate the adverse effects of banking crises, the economy is ex ante better off without bailouts: Having access to bailouts lowers the cost of defaults, which in turn increases the default frequency, and reduces the levels of debt, output, and consumption.
Keywords: bailouts; banking crises; sovereign risk; government intervention; financial stability
JEL Codes: E32; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Shocks to bank capital (F65) | Banking crises (G01) |
| Banking crises (G01) | Government intervention (bailouts) (G28) |
| Government intervention (bailouts) (G28) | Economic output (E23) |
| Larger bailouts (H81) | Economic output (E23) |
| Government debt levels (H63) | Fraction of banking losses covered by bailouts (G28) |
| Aggregate productivity (E23) | Fraction of banking losses covered by bailouts (G28) |
| Severity of banking crises (F65) | Fraction of banking losses covered by bailouts (G28) |
| Availability of bailouts (H81) | Default frequency (C69) |
| Availability of bailouts (H81) | Levels of debt (F34) |
| Availability of bailouts (H81) | Output (Y10) |
| Economic output (E23) | Default frequency (C69) |
| Economic output (E23) | Levels of debt (F34) |
| Economic output (E23) | Consumption (E21) |