Bailouts And Moral Hazard: How Implicit Government Guarantees Affect Financial Stability

The recent crisis has shown that banks in distress can often expect to benefit from (implicit) government guarantees. This paper analyzes a panel of 781 banks from 90 countries to test whether the expectation of individual and systemic government support induces moral hazard. It shows that banks tend to be more leveraged, funded with capital of lower quality, more heavily invested in risky assets and exposed to more severe liquidity mismatch when they themselves -but also when their competitors- are perceived as being more likely to benefit from government support. We show that the default of Lehman Brothers in 2008 reduced moral hazard in the short-run, but not in the long-run, as the systemic consequences of Lehman’s failure became apparent. In addition, our large country coverage allows us to provide new results on policies, institutions, and regulations that can be put in place to reduce moral hazard induced by implicit guarantees to the banking sector.