We present a dynamic, continuous-time model in which risk averse insideequityholders set a bank’s lending, payout, and financing policies, and the expo-sure of bank assets to crashes. We examine whether bailouts encourage excessivelending and risk-taking compared to liquidation or bail-ins with debt-to-equityconversion or ...
We present a dynamic, continuous-time model in which risk averse insideequityholders set a bank’s lending, payout, and financing policies, and the expo-sure of bank assets to crashes. We examine whether bailouts encourage excessivelending and risk-taking compared to liquidation or bail-ins with debt-to-equityconversion or debt write-downs. The effects of the prevailing insolvency resolu-tion mechanism (IRM) on the probability of insolvency, loss in default, and thebank’s value suggest no single IRM is a panacea. We show how a bailout fundfinanced through a tax on bank dividends resolves bailouts without public moneyand without distorting insiders’ incentives.