Bailout Policies When Banks Compete with Switching Costs

We analyze the effects of bailout policies on borrower surplus in a two-period Hotelling model of competition with switching costs and poaching. Before the second period of competition, banks may sometimes fail or face capacity constraints because of random shocks and uncertain bailouts. If borrowers are myopic, banks reduce the first-period interest rates according to their bailout expectations. We show that banks may reduce the first-period interest rates even more when borrowers anticipate a bank failure in the second period, whereas they may sometimes add a mark-up to the first-period interest rates if borrowers expect the market to remain stable. Higher bailout expectations have a different impact on the interest rates in markets with high and low switching costs. We derive the bailout policy that maximizes borrower surplus and show that it may sometimes be time-inconsistent