The Effect of Systemic Rescues on Risk Taking and Systemic Risk

Bailouts increase moral hazard and exacerbate risk taking (strategic effect). However, they also decrease the probability of actual failure, thereby increase firm value, which in turn decreases the individual incentive to take risk (value effect). I study the interplay of these countervailing effects in a stochastic dynamic game. The strategic effect dominates in concentrated markets, but firms take less risk in fragmented markets in the presence of bailouts. The overall effect of bailouts on systemic risk in steady state depends on competitive and entry conditions. Contrary to conventional wisdom, bailouts can reduce systemic risk overall